The financial crisis appears to have lowered how quickly the economy can grow in the long term, Fed Reserve Board Chairman Ben Bernanke said Tuesday.
Before the crisis hit, the growth rate of potential output was about 2.5%. But evidence indicates that the crisis has cut that rate, Bernanke said Tuesday in a speech at the New York Economic Club.
“There are a number of ways in which the financial crisis could have slowed the rate of growth of the economy’s potential,” Bernanke said.
Potential output combines the economy’s long-run productivity rate and labor force growth.
The high level of long-term unemployment could have led to a loss of skills, pushing up the rate of unemployment that can be sustained under normal conditions, Bernanke said.
At the same time, businesses have reduced investment, which has cut the pace of productivity gain, he added.
This could be at least a partial reason for the disappointing pace of the economic recovery, Bernanke said.
Josh Shapiro, chief U.S. economist at MFR Inc., said the Congressional Budget Office estimates that potential growth is near 1.6%.
Economists believe that the economy has to grow faster than potential to bring down the unemployment rate.
The unemployment rate has come down slowly to 7.9% in October from 9.4% in December 2011 even though economic growth has averaged only about 2% over the same period.
Lower potential GDP could also mean the economy needs less stimulus and interest rates may need to rise sooner than expected.
Michael Gapen, an economist at Barclays Capital, said that, with the lower potential output, the unemployment rate will decline faster than expected in a moderate growth environment.
In his weekly note to clients, Jim O’Sullivan, chief U.S. economist at High Frequency Economics, argued that job growth around 100,000 per month could bring down the unemployment rate. This is well below the 170,000 average pace of payroll growth seen over the past year and a half.
If this 170,000 per-month pace continues, it could result in the unemployment rate hitting 7% by the second half of 2014, O’Sullivan said.
“We think this will be an important issue to watch,” O’Sullivan said.
Charles Evans, the president of the Chicago Federal Reserve Bank, has set 7% as a possible threshold for when the Fed might have to start raising interest rates.
But Shapiro urged caution, noting that the unemployment rate might spike when discouraged workers return to the labor force to look for work.
In normal conditions, potential GDP also measures the highest level of output that can be sustained without sparking inflation.
But this speed limit does not apply with so much spare capacity in the economy, Shapiro noted.
Via – MarketWatch
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