Seeking A Second Wind

Although growth is accelerating, it remains in line with its long-term potential, which is not strong enough to substantially reduce over-capacities. The unemployment rate is falling, but neither quickly enough nor for the right reasons: the labour participation rate has dropped sharply. Under this environment, inflation remains very low, leaving the Fed rooms to act. Monetary policy is accommodative and will remain so for the foreseeable future. This is especially true since the US Congress is once again playing chicken with budget matters. Faced with this game of brinkmanship, the likely nomination of Janet Yellen as the next Fed chairwoman provides at least some visibility over one component of the policy mix.

A mixed analysis
If we wanted to paint a positive picture, we would highlight the fact that the US economy has resisted numerous headwinds since it pulled out of recession. In the second quarter of 2011, growth returned to its previous peak of year-end 2007. In August, the unemployment rate slipped to 7.3%, nearly three points below the year-end 2009 high. Over the span of three years, the US economy has created more than six million jobs.

Yet these undeniable improvements are still insufficient. The economy has not caught up the lag created by the recession, and GDP is still nearly 6 points below its potential, as estimated by the Congressional Budget Office (CBO). Job creations in recent years still fall far short of the 8.7 million jobs destroyed during and after the recession. Moreover, the decline in the unemployment rate over the past four years is mainly due to the sharp drop in the labour participation rate.

In brief, although the newsflow is rather encouraging, the damage inherited from the crisis has yet to be completely absorbed. Two of the most telling measures concerning the under utilisation of capacities are the gap between observed unemployment and the NAIRU (Non-Accelerating Inflation Rate of Unemployment), and the output gap. Both measures are abstract and cannot be measured directly. The CBO currently estimates the output gap at about 6 points of GDP and the NAIRU at 5.5%, but other institutions provide different estimates.

One thing they all agree on, however, regardless of the size of their estimates, is that the shortfalls exist, and that they are substantial. They are reflected in the absence of inflationary pressures, even though monetary policy has been highly expansionist in recent years. Generally speaking, weak demand leads companies to cut back on supply, resulting in surplus production capacity. Sales prices are slashed in order to reduce excessive inventories. In the job market, employees cannot hope for wage increases in a fiercely competitive environment (abundant supply of available labour). The shortage of demand fuels the emergence of surplus production capacity, which in turn accentuates the downward pressures on prices...

BY Alexandra ESTIOT

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