In its first or “advance” estimate, the Bureau of Economic Analysis (BEA), reported that the nation’s economy, as measured by real gross domestic product (GDP), rose by 2.3 percent on a seasonally adjusted annual rate basis in the first quarter of 2018. This is the second consecutive quarter in which growth slowed. However, this is the fourth consecutive quarter in which actual growth exceeded an estimate of the economy’s potential growth. On its own, the new estimate of the nation’s potential, which partly reflects the impact of the Tax Cuts and Jobs Act, provides support for gradual increases in the short-term policy rate.
As illustrated in the figure above, GDP grew by 2.3 percent in the first quarter of 2018. Today’s release indicates that the US economy has exceeded its potential growth rate as estimated by the Congressional Budget Office (CBO). However, the spread between actual GDP growth and the economy’s potential growth has narrowed as well. The convergence of actual GDP growth partly reflects a slowdown in actual GDP growth, but the economy’s potential has accelerated somewhat as well.
Over the first quarter of 2018, the slowdown in actual GDP growth reflected slower growth in personal consumption expenditures (PCE). It also reflected a slowdown in government consumption expenditures as well as exports. Since PCE accounts for approximately 70 percent of GDP, then the slowdown in this category had the largest impact on GDP growth. In the fourth quarter of 2017, the 4.0 percent growth in PCE translated into a contribution of 2.8 percentage points to GDP growth. In the first quarter of 2018, the 1.1 percent growth rate in PCE translated into a 0.7 percentage point contribution to GDP growth. Imports detract from GDP, so the slowdown in imports growth means that its negative contribution was smaller.
At the same time, the estimate of the economy’s potential has strengthened although it remains below the growth rates that prevailed prior to the recession. This in part reflects the acceleration of potential GDP from the third quarter of 2017 to the first quarter of 2018. At the same time, the CBO’s most recent estimate of potential GDP indicates that the economy’s potential is stronger than was believed when this exercise was completed in June 2017. The new estimate of the economy’s potential growth is now faster than its last estimate between 2015 and 2023, most notably starting in the first quarter of 2018. The economy’s potential growth is slower than last estimated in the subsequent years.
According to a report by the CBO, “The recent tax cuts will, in CBO’s view, increase the supply of labor and capital in the economy, thereby raising potential output throughout the projection period. Nevertheless, because the tax cuts boost after-tax incomes, they, along with the increases in federal spending, are expected to add excess demand in the next few years. Near the end of the projection period, the scheduled expiration of the reduction in tax rates on personal income temporarily and slightly reduces demand in the economy.”
As a result of a higher estimate of potential GDP, the difference between the level of actual GDP and its potential level, the output gap, is lower. More importantly, the output gap, after today’s release, is negative, indicating that actual GDP has not yet recovered or returned to its potential level. This is in contrast to the calculation of the output gap under the last estimate of potential GDP, which exceeded zero in the third quarter of 2017, indicating that the economy may have recovered as the level of actual economic output exceeded its potential level. Nevertheless, the current estimate of the output gap, while negative, is very near to zero.
ἰ = ∏ + r* + [.5 * (∏ – 2%)] + [.5 * (YActual – YPotential)]
This is important because the output gap, the difference between actual GDP and its potential level is a key input into a basic Taylor rule, a formula that estimates the appropriate level of the federal funds rate (ἰ). A positive output gap, (YActual – YPotential), puts upward pressure on the calculation of the appropriate level of the federal funds rate. A negative output gap, even small, puts downward pressure on the federal funds rate, suggesting more room for gradual tightening. However, inflation (∏ or (∏ – 2%)) and expectations of faster inflation would put upward pressure on the federal funds rate. Also, the underlying strength of the economy, r*, influences the Taylor rule as well. Just as importantly, monetary policy by the Federal Reserve is not a rules-based decision, although the Taylor rule, using various inputs, is an informative part of their deliberation process.