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Fed’s Yellen says economy has ‘more room to run.’ What does that mean?

Janet Yellen, chair of the U.S. Federal Reserve. (Pete Marovich/Bloomberg News)
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In a news conference yesterday, the chair of the Federal Reserve, Janet Yellen, told reporters, “The economy has a little more room to run than might have been previously thought. That’s good news.”

What does that mean? And is it really good news?

It means that there’s still slack in the economy. Labor, for example, is not fully utilized, meaning there are still people working part time who’d rather work full time (about 6 million, or 4 percent of those employed). While the share of working-age folks is climbing back from its trough, it is but two-thirds of the way back (see figure).

That last bit is really important. The way Yellen thinks about it, I suspect, is: “There’s still a not-fully-tapped elasticity there, so no brake-tapping yet.” In English, the improving job market is pulling people back in, and there remain significant numbers to be so pulled. Not only does that help them and their families, of course. It helps the overall economy.

Let me explain. The figure below has three lines: actual real GDP, pre-Great Recession potential GDP, and post-recession potential GDP. “Potential” in this context is highly relevant to Yellen’s “room-to-run.” It means this is the level of GDP we’d expect if the economy’s resources (labor, capital) were fully utilized. So the gap between the post-recession potential and the actual lines are one version of “running room.”

But why did potential come down so much since the downturn? That’s a real loss of some serious income. In part, because estimates of the key growth ingredients — the growth of the labor supply and productivity — fell since 2007. But if holding off on the rate hike can pull more people in, i.e., increase labor supply, it can raise potential GDP. In this regard, and this is key: Allowing for more running room can create more running room.

Productivity is a lot trickier, but I’ve made the same argument there: Allowing the economy to run hot will force firms to squeeze out inefficiencies that are all too affordable in weaker economies. I call it the FEPM (full-employment productivity multiplier; catchy, no?).

Our last picture of “running-room” is the unemployment rate itself. It’s already historically low, at 4.9 percent, as you see in the first bar of the figure below. Not a few economists, mistakenly in my view, believe that we’re already at full employment (so no more running room). But some of the Fed governors, bless their hearts (and minds), argue that at least in the near term (over the next couple of years), the lowest unemployment rate consistent with stable inflation is closer to 4.5 percent. Again, more running room.

That benchmark unemployment rate has fallen in recent years as the decline in the actual jobless rate has failed to boost inflation. Yellen and some of her colleagues, in an admirably data-driven mode, have responded by recognizing that there’s more room for growth than they thought, and that has led them to hold off on raising rates.

Which is all by way of saying the following. I know this stuff is obscure, but trust me: If you’re someone who has a job, draws a paycheck, supports a family, services a mortgage, or is simply doing all you can to make ends meet, take a moment today and say thanks to Yellen. She’s got your back.