Cooling needed? Former Fed Chair Yellen says U.S. growth may need to slow
Growth accelerated earlier this year. But Dr. Janet Yellen says the economy likely needs a slowdown to avoid overheating and slipping into recession.
With her talent to synthesize complex macroeconomic data and trends into clear, concise comments that investors can appreciate, Yellen spoke candidly with advisors at Schwab's IMPACT® conference about the U.S. economy and how the Fed directs monetary policy. Yellen believes the stronger growth the economy logged in recent quarters likely isn't sustainable.
Interviewed by CNBC senior economics reporter Steve Liesman, Yellen shared her outlook about the U.S. economy's current trajectory and the influence of interest rate policy. They spoke at the close of October, a tumultuous month for the stock market in recent years. Yellen said the return of volatility shows how concerned investors are about heightened uncertainty around issues such as trade tensions, interest rates, the global growth outlook, and stock multiples that were trading close to the top of their historic ranges.
Supportive economic backdrop
Despite such worries, Yellen pointed out that the economic backdrop is still favorable. Overall, financial conditions are still accommodative. Though they're trending up, interest rates are still historically low, allowing consumers and businesses to keep their borrowing costs down. Unemployment is at a 50-year low, and there are now more job openings than workers to fill them.
She said she fully expects the U.S. economic expansion to continue into next July, which would make it the longest on record. That’s because expansions don’t die of old age, and conditions that normally tip economies into recessions—such as financial imbalances—aren’t evident.
Still, Yellen cautioned that there are risks to the economy, and one of the biggest is overheating. She said the economy’s recent uptick in growth likely isn’t sustainable, given the historically tight labor market and the inflationary pressure that low unemployment is starting to exact on wages and prices.
A difficult balancing act
Enter the Federal Reserve, which has the difficult balancing act of needing to hike rates further to help suppress inflation without going so far as to significantly cool economic activity. "They have the ability to approach their task of slowing down the economy, stabilizing it in a gradual and thoughtful way, but it's not an easy thing to do, and it could cause a recession," Yellen said.
Asked by Liesman about the risk of recession in the next five years, Yellen put the odds at one in five, with the year 2020 the most likely. Along with overheating, another factor she listed as potentially contributing to a recession between now and then includes fiscal policy that transitions from stimulative to restrictive as the impact of tax cuts and other government spending wears off. She also warned of restricted trade with countries that have major economies, such as China. Even if a recession hits, she said that it's likely to be shallow given the currently low starting point for unemployment.
Why growth needs to slow
The U.S. economy reported its best quarterly performance in four years in the second quarter, with a 4.2% annualized rate of growth. The second estimate of third-quarter figures released by the Bureau of Economic Analysis showed slowing from that pace at 3.5%, but even at that rate the economy is still growing too fast, Yellen said.
That's because the long-term potential growth rate of the economy is now about 2%. For the economy to grow faster than that on a sustainable basis, she said that a long-forming slowdown in productivity growth has to reverse course, and the labor force has to grow meaningfully, such as by allowing more immigration. Her views are in line with those of current Fed Chair Jerome Powell, who said in late November that the economy doesn't have enough labor or productivity for faster growth. He is on record saying that reduced immigration could slow the current pace even further.
Without reversing those trends, the tightening labor market could drive up wage and price inflation, Yellen said. Core inflation is around 2%—consistent with the Fed's target—but could easily surpass that if the economy continues to add 200,000 jobs per month, a level that is far more than is required for new entrants into the labor market. "My judgment is growth needs to slow in order for the economy not to overheat," Yellen said.
More rate hikes in store
This all means that the Federal Reserve must keep raising short-term interest rates, she said. Since December 2015, the Fed has steadily increased the federal funds rate from close to zero to a range of 2% to 2.25%. While the Fed held firm at its November 7–8 meeting, its own economic projections have it raising rates three more times before the end of 2019.
Powell has faced some criticism from the current U.S. administration about raising interest rates at a time when inflation is low. But Yellen pointed out that monetary policy takes time to have an impact on the economy, and the Fed can't wait for inflation numbers to move higher before acting. She pointed to the 1970s period of hyperinflation, when the Fed fell behind the curve and inflationary expectations became self-fulfilling. If the Fed doesn't get ahead of inflation now, Yellen said, it will have to hike rates more aggressively in the future, to the point where a recession would be much more likely.
Yellen said there is still room to boost short-term rates before the Fed reaches what economists call "the neutral rate of interest," or one in which rates neither stimulate nor restrain the economy. She said that, with inflation running at 2%, the current range for the federal funds rate leaves the real rate of interest—after backing out inflation—at around zero. At his recent speech at the end of November, Powell said that interest rates are "still low by historical standards" but added that they remain "just below" neutral.
Normally, real interest rates tend to average about 2%, Yellen said, but their long-term trend has fallen to about 1% due to increased levels of saving after the global financial crisis. Liesman asked Yellen to confirm if that meant the Fed would need to raise rates at least three more times to reach that level, and she confirmed that as the case, adding the possibility of more hikes if the labor market continues to tighten.
"It may turn out to be the case that inflation is going to pick up to levels that exceed the Fed's objective, and they have to relieve some of that tightness by going into a restrictive position," she said.
We hope Janet Yellen's remarks give you more insight into the current state of the U.S. economy and offer talking points with clients as the year draws to a close.
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