The U.S. economy heads into the New Year with considerable strength. Real gross domestic product – our most comprehensive measure of inflation-adjusted income and spending – expanded at an annual rate of 4.75 percent in the second and third quarters of 2014. Nonfarm payrolls have grown by more than 2.7 million over the past 12 months, and the unemployment rate has declined from 7.0 to 5.8 percent over the same period. No one can deny that these are impressive numbers.
Moreover, the healthy fundamentals that have served as underpinnings for this acceleration in growth have improved still further in recent months. As noted in my previous commentary for E21, robust growth in broad measures of the money supply indicates that Federal Reserve policy continues to provide considerable support. Six percent growth in the M2 measure cited in my column, for example, is fully consistent with a baseline scenario in which core inflation converges back to its two percent target while real economic growth proceeds at a pace similar to what we have already seen in the second half of 2014.
Against this backdrop, Federal Reserve officials will have to act, certainly towards the middle of next year and perhaps even sooner, to begin moving interest rates back to more normal levels. But these higher rates are nothing to be feared. To the contrary, they are a necessary component of a broader policy strategy designed to keep the economy growing along a stable path while maintaining the environment of slow-but-steady inflation that has served the country so well, going back more than a quarter century to the days of Paul Volcker’s Fed chairmanship.
In the meantime, the sharp decline in world oil prices provides a much-needed break for American consumers, who can now take some of the money they might have spent just to drive to and from work and heat their homes this winter, and either spend it on other goods and services or set it aside in the form of higher savings. Either way, the dynamics are favorable. Higher spending helps American businesses directly, and higher savings translates into more investment as well, to start new businesses and expand existing ones. More jobs and higher incomes follow.
Finally, political changes brought about by the most recent national elections invite at least cautious optimism. Leaders in Congress now have a clear path to pass the legislation they feel will help the country most, while President Obama retains the power to veto initiatives that pay insufficient attention to his priorities. This allows the system of checks and balances to work in exactly the way our nation’s Founders intended: to produce laws that embody compromise and are therefore acceptable to the vast majority of Americans. Much needed pressure on both sides to show skill in governance should steer the agenda towards low-hanging fruit. Everyone agrees that the federal tax code could be simplified in ways that provide stronger incentives for income growth and job creation, while closing down channels that facilitate the worst kind of crony capitalism that we’ve seen since the days of the financial crisis. So make it happen! Then, with renewed confidence, leaders on both sides can turn their focus to the trickier issues, especially reform of our national retirement and health-care programs, that will put our federal budget on sounder long-term footing.
With so many favorable conditions now in place, it has become increasingly clear that the biggest “risks” to popular forecasts, which still show GDP advancing at rates between 2.5 and 3 percent for 2015, lie to the upside. Instead, with headwinds clearing, growth in the 3.25 percent range – and maybe even higher – stand well within the range of possibilities. Commensurate gains in employment are quite likely to appear as well, in addition to further gains in wages, first observed in November.
Whatever the immediate future holds, however, the convergence of these favorable economic and political trends ought to remind us of enduring lessons that can be found in the writings of John Locke, Adam Smith, and Milton Friedman, to cite just a few of the classics. The basic messages contained in this work – that all persons are endowed with inalienable rights, that all government powers are limited and granted only by the consent of the people, and that free and fair markets provide the only reliable mechanism for both growth in and the equitable distribution of national incomes – are ones that will continue to apply with full force during 2015.
In Havana, Moscow, and Pyongyang, we see quite clearly what alternatives have to offer. Instead, only the combination of liberal democracy and free market capitalism allows for the highest forms of human achievement. That is not a prediction; it is a fact.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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