As the Baby Boom generation retires, economic growth may slow and fiscal deficits could grow, complicating monetary policy, Federal Reserve Bank of Kansas City President Esther George said late Thursday.

“If the neutral rate of interest remains historically low, monetary policy may have less scope to stimulate the economy in a downturn without again resorting to unconventional policies such as asset purchases,” she told the Wichita Independent Business Association, according to prepared text release by the Fed. “A natural response to such a situation would be to rely more heavily on fiscal policy. However, the longer-run fiscal outlook suggests that fiscal policy may be similarly constrained. Thus, it is critical that the longer-run budget issues associated with our aging population be addressed sooner rather than later.”

Federal Reserve Bank of Kansas City President Esther George.
Federal Reserve Bank of Kansas City President Esther George. Bloomberg News

Monetary policy is still “quite accommodative” and well below its 3% estimated longer-run level, while the Fed’s balance sheet is bloated as a result of quantitative easing, which the Fed has begun slowly reversing.

Tax reform will boost the economy, she said, but by how much, “is hard to tell at this stage.”

The Bank’s manufacturing survey indicates a rise in expectations of future activity since tax reform passed. “Overall, I expect that lower personal tax rates will boost aggregate demand, and that a lower corporate tax rate and the more favorable tax treatment of investment spending will increase aggregate supply, although it is difficult to predict exactly how and when consumers and businesses will respond.

“The result is that an uncertain degree of fiscal stimulus is arriving at the same time the economy is operating at or beyond full employment and monetary policy remains accommodative,” George said. “And because of that, it is important that the FOMC continues on its current path of policy normalization with gradual increases in the target federal funds rate.”

The Federal Open Market Committee Summary of Economic Projections suggests three 25 basis point hikes in 2018 and again in 2019. “This is a reasonable baseline unless the outlook changes materially.”

Other long-term issues, beyond the scope of monetary policy, “will nevertheless have implications for economic growth, employment and inflation and deserve careful monitoring,” she added.

She noted a drop in the economy’s potential growth rate, resulting from a shrinking workforce and related productivity drops. “Due largely to demographic changes, especially the retiring of the Baby Boom generation, the annual growth rate of our labor force is only a little better than one-third of what it was in the 1990s,” she said. “At the same time, productivity growth is about one-half what it was in the 1990s. Both of these unfavorable trends are projected to persist over the next decade. While these projections are highly uncertain, if they prove accurate, we can expect, among other things, a slower rate of improvement in living standards relative to the pre-crisis period.”

And what does this mean for monetary policy? “For one thing, it has led many economists to lower their estimate of the interest rate that is consistent with full employment and price stability,” George noted. The median expected longer-run fed funds rate is around 3 percent, down considerably from even a few years ago.

“This means that a future FOMC may have substantially less room to lower the federal funds rate should conditions warrant an increase in monetary stimulus,” she said. “In such situations, for example a future recession, it might prove helpful for fiscal policy to step in and provide a countercyclical stimulus.”

However, that would add to “the unsustainable trend of government debt,” which is another long-term challenge she cited.

“Demographic trends will raise government spending as an increasing share of the population receives retirement and health care benefits,” George asserted. “Additionally, health care costs are projected to grow faster than the economy, as are the federal government’s net interest costs. In all, federal debt held by the public, which was equal to about 35 percent of GDP before the recession, is now up to 75 percent of GDP. It is projected to exceed its historical (WWII) peak of 106 percent by the 2030s, barring a shift in fiscal policy. The nation remains far from a fiscal crisis, but changes will be necessary to put government debt on a sustainable trajectory in the coming decades. The sooner these changes can be made, the less drastic they will need to be and the better positioned fiscal policy will be to take a more prominent countercyclical role in any future downturn.”

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