Is the Economy Doing Too Well?

Unemployment is low, the stock market is booming, and the economy continues to grow.

In short, things are pretty great. But are they too great?

After Federal Reserve Chair Jerome Powell's press conference on Wednesday, The Wall Street Journal published an analysis suggesting that unemployment is well below the so-called natural rate of unemployment, and predicted that "by 2020 the economy will be well into overheating territory, the sort of situation that usually leads to dramatically higher interest rates and a recession."

Federal reserve officials project that the jobless rate will drop to 3.5 percent by the end of 2019, significantly lower than the approximately 4.5 percent natural unemployment rate—that's the term economists use to describe the minimum unemployment that can exist in a healthy market economy.

All this, in the Journal's Greg Ip's view, suggests an economy that's growing too fast and could overheat, leading to a recession.

Mainstream economists typically use the phrase "overheated economy" to describe an economy that has had extended economic growth leading to high inflation because of the greater wealth held by consumers. This can lead to an inflationary spiral and a recession, or so their logic goes. As Ip says, "so long as unemployment is below its natural rate, inflation will tend to go up, not down." To prevent this, central banks such as the United States' Federal Reserve step in to raise interest rates and, effectively, save the economy from its own success.

This reasoning is dubious at best. Inflation is often defined as a general increase in price levels, but that is simply a consequence of inflation. Inflation is really an increase in the money supply, which consequently makes each dollar less valuable, therefore increasing the prices of goods and services. If individuals in the marketplace are wealthier, and thus spending more, there will be no "overheating," provided the resources exist to meet the production requirements.

"I don't think the way to think about price inflation is to look and see what the unemployment rate is," argues Robert Murphy, research assistant professor at the Free Market Institute at Texas Tech University and senior fellow at the free-market Mises Institute. "Yes, you can see correlations, but it's not that the unemployment rate causes price inflation. It misleads people."

Does this mean that there's nothing to worry about? Far from it. The Federal Reserve's policy of artificially holding down interest rates is the real problem.

"Since the fall of 2008 and beyond kept interest rates artificially low, with its easy money policy that created an unsustainable boom. That fueled bad investments and now that the Fed is raising rates, those malinvestments are going to reveal and manifest themselves," says Murphy.

With the low interest rate policies espoused by the Federal Reserve, people are more inclined to borrow in order to invest in long term projects. However, the resources for those projects don't exist, which pulls them away from goods actually demanded, thus leading to malinvestments, which eventually causes a "bust," as the economy purges itself of the unsustainable investments of the boom.

So yes, Ip is right that a recession is a-coming, but it's not because the economy is growing too fast and overheating. As Murphy says, "The economy is not like an engine that's going too hard." So let's stop analyzing it like one.