By Frances Coppola
The Federal Reserve uses estimates of the “sustainable” rate of real economic growth, g* (pronounced “g-star”), to help it determine the right rate of interest for the economy. A lower g* implies lower interest rates than before the crisis. But is recent lower growth simply post-crisis blues, or is something deeper and more structural going on—and what could this imply for exchange rates and FX risk management in the future?
Prior to the Great Recession, the U.S. economy was on a tear. From 1995 to 2001, the economic growth rate averaged 4 percent per annum.1 It briefly dropped to zero in 2001 due to a combination of the dot-com crash and the September 11 disaster, but then bounced back, helped by the Fed cutting interest rates to then-unprecedented lows. By the fourth quarter of 2003, interest rates were still at 1 percent2 but the economy was once again growing at over 4 percent per annum.3 The dollar’s trade weighted exchange rate had fallen by some 10 percent since its peak in early 2002.4
John Williams, Governor of the New York Federal Reserve, says the economic boom of the late 1990s and early 2000s was driven by high productivity growth due to technological change.5 But from approximately 2002 onwards, rapid credit growth created a bubble in property and financial assets.
The Fed started to raise interest rates in mid-2004. Economic theory says that the dollar’s exchange rate should strengthen when U.S. interest rates rise, since higher interest rates increase demand for the dollar. However, although the dollar’s trade-weighted exchange rate stabilized while the Fed was raising rates, it continued its downwards trend in 2006 as economic growth tailed off.6
Many economists at the time thought the U.S.’ strong growth rate was sustainable. But the fact that the dollar’s trade-weighted exchange rate did not rise significantly when the Fed raised rates, and fell when it stopped raising rates, suggests that FX markets may have had a different view.
The credit-fueled economic boom was brought to an abrupt end by the fall of Lehman Brothers in 2008 and the ensuing Great Recession. Many economists now think that fast credit-fueled growth of the kind seen before the financial crisis inevitably results in a bust, and question whether 4 percent is a sustainable long-term growth rate for the U.S. economy.
Williams says that in the future, g*—the sustainable real (i.e., inflation-adjusted) GDP growth rate for the U.S.—could be significantly lower than the 4 percent of the boom years.7 He estimates it could be as little as 1.5 percent.8 But historically, real GDP growth of 4 percent per annum is not particularly strong. During the 1950s and 1960s, U.S. economic growth averaged over 5 percent per annum.9 Why might economic growth be lower now?
Economists believe lower g* could, in part, stem from falling labor force growth. After World War II, there was a “baby boom” lasting from 1945 till approximately 1965. When the baby boomers reached adulthood, they caused a considerable expansion of the labor force, which some economists think contributed to rising inflation and unemployment in the 1970s. Now, baby boomers are retiring. Additionally, fertility rates have fallen considerably since the baby boom years. The combination of falling fertility rates with baby boomers leaving the workforce is causing a sharp decline in labor force growth.
However, declining labor force growth alone can’t fully explain lower economic growth, since it could be counteracted by rising productivity—simply, the output of each worker per hour. Higher productivity arises from technological advances and investment in skills.
During the late 1990s technology boom, productivity was rising at 2-3 percent per annum, which was more than enough to offset a falling fertility rate. G* may therefore have been quite close to the 4 percent average real growth rate during this time. But since the Great Recession, productivity has risen at only about 1 percent per annum.10 Combined with the declining labor force growth rate, this implies that g* has fallen significantly.
British economist Jonathan Haskel says that risk aversion and inefficiency in the financial system since the crisis has inhibited business investment in “intangibles” such as information technology. He believes this has held back productivity.11 If he is right, then as the financial system stabilizes, productivity could pick up again, enabling g* to rise.
But other economists think that the productivity slowdown has little to do with the crisis. On the bright side, some claim that productivity is underestimated because information technology output is not easily measured: as measurement techniques improve, productivity and economic growth may seem to rise.12 Others say that it is not technology itself that drives rising productivity, but the way it is used, which again could become more efficient over time: for example, John van Reenen of MIT argues that the quality of business management is a considerable driver of productivity improvement.13
However, other economists say that the “low-hanging fruit” of technological advances have all been plucked, and productivity improvements are now harder to come by.14 Additionally, the dominance of very big businesses may make it hard for small innovative companies to scale up and expand.15 If this results in a long-lasting productivity slowdown, it could mean lower economic growth and associated low interest rates far into the future.
But sharply declining labor force growth and weak productivity are not limited to the U.S. Labor markets in Europe are growing much more slowly than they did in the post-war period, and Japan’s population is actually falling. Productivity improvement has been declining in most developed countries since the mid-2000s.16 In future, therefore, both sustainable growth and interest rates may be lower across the developed world than they were in the past. If so, then “lower for longer” interest rates in the U.S. may have little effect on the dollar’s exchange rate.
Sharply falling labor market growth and declining productivity seem to be putting downwards pressure on the U.S.’ sustainable growth rate, g*. As this influences the Fed’s interest rate policy, it may mean interest rates remaining lower than their pre-crisis level. Businesses trying to manage their FX risk may consider that if the U.S. was the only country experiencing these changes, persistently low interest rates would mean a lower dollar exchange rate. However, as labor market growth is falling and productivity weakening across much of the developed world, implying lower interest rates in other countries too, there could be little effect on dollar exchange rates.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Real gross domestic product,” Federal Reserve Economic Data (FRED) https://fred.stlouisfed.org/series/GDPC1#0
2. “Effective Federal Funds Rate,” FRED https://fred.stlouisfed.org/series/FEDFUNDS
3. “Real gross domestic product,” FRED https://fred.stlouisfed.org/series/GDPC1#0
4. “Trade-weighted U.S. Dollar Index, Broad, Goods,” FRED https://fred.stlouisfed.org/series/TWEXB
5. “The Economic Outlook: The ‘New Normal’ Is Now,” Williams, https://www.newyorkfed.org/newsevents/speeches/2019/wil190306
6. “Trade-weighted U.S. Dollar Index, Broad, Goods,” FRED https://fred.stlouisfed.org/series/TWEXB
7. “The Economic Outlook: The ‘New Normal’ Is Now,” Williams https://www.newyorkfed.org/newsevents/speeches/2019/wil190306
8. “Interest Rates And The New Normal,” Williams https://www.frbsf.org/our-district/press/presidents-speeches/williams-speeches/2017/october/interest-rates-and-the-new-normal/
9. “Real gross domestic product,” FRED https://fred.stlouisfed.org/series/GDPC1#0
10. “Interest Rates And The New Normal,” Williams https://www.frbsf.org/our-district/press/presidents-speeches/williams-speeches/2017/october/interest-rates-and-the-new-normal/https://www.newyorkfed.org/newsevents/speeches/2019/wil190306
11. “The rise of the intangible economy: how capitalism without capital is fostering inequality,” Haskel https://www.imperial.ac.uk/business-school/knowledge/finance/rise-intangible-economy-capitalism-without-capital-fostering-inequality/
12. “Productivity slowdown or measurement problem?” Tyler Cowen, https://marginalrevolution.com/marginalrevolution/2016/03/productivity-slowdown-or-measurement-problem.html
13. “Good managers, not machines, drive productivity growth,” Van Reenen http://mitsloanexperts.mit.edu/good-managers-not-machines-drive-productivity-growth-john-van-reenen/
14. “Technology and the Great Stagnation: Has All the Low-Hanging Fruit Been Picked?” Forbes https://www.forbes.com/sites/erikkain/2011/11/16/technology-and-the-great-stagnation-has-all-the-low-hanging-fruit-been-picked/#98d6be224c88
15. “Productivity is key to economic growth: Why is it slowing down in advanced economies?” Brookings https://www.brookings.edu/blog/up-front/2017/09/25/productivity-is-key-to-economic-growth-why-is-it-slowing-down-in-advanced-economies/