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America’s Risky Recovery

CAMBRIDGE – The United States’ economy is approaching full employment and may already be there. But America’s favorable employment trend is accompanied by a substantial increase in financial-sector risks, owing to the excessively easy monetary policy that was used to achieve the current economic recovery.

The overall unemployment rate is down to just 5.5%, and the unemployment rate among college graduates is just 2.5%. The increase in inflation that usually occurs when the economy reaches such employment levels has been temporarily postponed by the decline in the price of oil and by the 20% rise in the value of the dollar. The stronger dollar not only lowers the cost of imports, but also puts downward pressure on the prices of domestic products that compete with imports. Inflation is likely to begin rising in the year ahead.

The return to full employment reflects the Federal Reserve’s strategy of “unconventional monetary policy” – the combination of massive purchases of long-term assets known as quantitative easing and its promise to keep short-term interest rates close to zero. The low level of all interest rates that resulted from this policy drove investors to buy equities and to increase the prices of owner-occupied homes. As a result, the net worth of American households rose by $10 trillion in 2013, leading to increases in consumer spending and business investment.

After a very slow initial recovery, real GDP began growing at annual rates of more than 4% in the second half of 2013. Consumer spending and business investment continued at that rate in 2014 (except for the first quarter, owing to the weather-related effects of an exceptionally harsh winter). That strong growth raised employment and brought the economy to full employment.