Economist William Yu, in a recent online lecture, conducted an in-depth analysis of the American economy, discussing the possibility and extent of future interest rate cuts, and making predictions about the future outlook of the US economy.
Dr. William Yu is an economist at the UCLA Anderson Forecast, specializing in economic modeling and research on US-China economic relations. His expertise covers a wide range of topics, with many of his papers widely cited by major media outlets.
On September 18th, the Federal Reserve initiated a period of easing, marking the first rate cut in four years with an extraordinary and significant 0.5% reduction. Following the Fed’s rate cut decision, US stocks rose, bond prices rebounded, yields decreased, and gold prices surged. Just before the rate cut, the US Bureau of Labor Statistics released a preliminary estimate on the nonfarm payroll employment figures, showing a reduction of 816,000 jobs as of March 2024. This adjustment, equivalent to 0.5%, was significantly higher than the average of 0.1% over the past decade, indicating a more subdued employment growth than previously reported.
Dr. Yu stated that the recent substantial 0.5% rate cut by the Fed was mainly due to signs of cooling in the US labor market. He referenced the year-over-year growth rates of nonfarm employment during the economic recessions in 1991, 2001, and 2008, explaining that when the employment growth rate declines from 2% to 1%, it indicates emerging issues in the labor market, often closely tied to business operational difficulties and layoffs. The Fed recognized these signs and opted for rate cuts to stimulate the economy in order to prevent a recession.
Despite the Fed’s efforts to stimulate the economy through rate cuts, Dr. Yu stressed that this does not signal a return to the era of negative interest rates. He emphasized that the past two decades of negative interest rates were highly unusual and are unlikely to recur. He suggested a gradual return to a normal era of average interest rates, with the historical average real short-term interest rate standing around 1.5%, representing the actual borrowing costs for consumers or businesses.
He explained that the calculation of the real short-term interest rate involves subtracting the core personal consumption expenditures (PCE) inflation rate from the federal funds rate. This rate effectively reflects the actual borrowing costs for consumption and investment. Dr. Yu noted that historically, excessively low or negative real interest rates could lead to overinvestment, asset bubbles, excessive consumption, and inflationary pressures.
According to Fed forecasts, the inflation rate is expected to reach 2.6% by the end of this year, decreasing to 2.2% next year, and further dropping to 2% the year after. Meanwhile, the federal funds rate is projected to be 4.4% at the end of this year, declining to 3.4% by the end of next year, and further dropping to 2.9% by the end of 2026.
Dr. Yu pointed out that deducting the inflation rate from the federal funds rate reveals the Fed’s expected real interest rates to be around 1.8% this year, 1.2% next year, and 0.9% the year after, roughly staying around 1% in the coming years. He believed that this reflects the Fed’s cautious stance on the interest rate levels in the current economic environment, deeming it to be within a reasonable range. “The era of negative real interest rates is long gone,” he said.
Although there are indications of a slowdown in inflation, Dr. Yu noted that the current inflation levels, when viewed in year-over-year growth, remain higher than the standards seen in the past three economic downturns. Furthermore, recent data revealed that the core PCE inflation rate was at 2.2%, which made many optimistic about nearing the Fed’s 2% target. However, Dr. Yu emphasized that the core inflation rate is the aspect that requires closer attention.
The core inflation rate remained high at 2.7%, rising by 0.1% from July, while the core Consumer Price Index (CPI) reached 3.3%. This indicated that the battle against inflation was not yet fully won, requiring careful actions. Dr. Yu expressed concerns that the significant rate cut might increase the risk of inflation.
He stated that if inflation rises, the likelihood of continued rate cuts would significantly diminish, as the Fed would need to suppress prices and control inflation. On the other hand, rate cuts also brought positive effects, reducing the risks of an economic downturn in the short term. Some believe that the rapid rate cuts by the Fed were due to foreseeing an impending economic recession, but he disagreed, stating that the current situation is different.
Despite the softness in the US labor market and the pressure of rising inflation, Dr. Yu still predicted that the US economy would not fall into recession. He attributed this to various complex factors behind the scenes. Three main factors have helped the US economy withstand the challenges brought on by inflation and rate hikes in the past three years.
Firstly, the state of US energy production is noteworthy. Due to the revolution in shale oil extraction technology, the US currently stands as the world’s largest producer of oil and natural gas, a key factor in curbing inflation.
Secondly, there has been a significant increase in manufacturing plant construction in the US. With the passage of the Infrastructure Investment and Employment Act of 2021 and the Chip and Science Act of 2022, US manufacturing investment has surged from $80 billion to $240 billion over the past two to three years, closely related to policies aimed at strengthening supply chain resilience.
This investment growth reflects a shift in US policies; while rate hikes traditionally have negative impacts on construction activities, the expansion in manufacturing has essentially offset the decline in residential construction, becoming a crucial pillar of the economy.
Thirdly, there has been a remarkable increase in US labor productivity – with an annual growth rate of approximately 2% to 3%. This suggests that, with the same amount of labor input, the US can produce more products, leading to higher incomes and increased consumption. This is extremely positive news; if this trend continues, it could benefit not only the US economy but also the global economy. Labor productivity is a key factor in improving a country’s long-term standard of living. Particularly after the 2008 financial crisis, labor productivity has not performed well, but recent improvements are worth noting, possibly linked to technological advancements, especially in AI, bringing new momentum to the economy.
Lastly, when discussing the US real estate market, Dr. Yu mentioned that over the past few decades, the annual number of new residential constructions in the US has averaged around 1.5 million units, consistent with population growth rates, showing no apparent signs of market imbalance.
This is one of the reasons why he believes the likelihood of an economic recession is relatively low, as the current real estate market does not exhibit clear signs of imbalance.
He noted that over the past few years, high interest rates had indeed significantly impacted commercial real estate. Especially with the trend of remote work post-COVID-19, it led to price declines even surpassing the levels seen during the economic downturn. While the overall economy has not fallen into recession, the office market has essentially entered a state similar to that of the economic downturn.
He also mentioned that over the recent quarters, this market seemed to have bottomed out. For those with capital, the current substantial drop in commercial real estate prices might present a good long-term investment opportunity. ◇