By many measures, the U.S. economy is powering ahead.
The GDP is on track to grow at around 3 percent this year, and the unemployment rate is an impressively low 3.9 percent. For President Donald Trump, it is an unmissable opportunity to gloat.
On Sept. 10, he described the economy as "soooo good" and "perhaps the best in our country's history." But for others, the very same figures present an economic puzzle.
The Federal Reserve has been raising its benchmark interest rate since December 2015, and will probably do so again this month, from a range of 1.75-2 percent to 2-2.25 percent. This is the central banker's version of twiddling the bath taps, but on a national scale.
It requires a delicate touch. Too much cold water, in the form of higher rates, will choke off demand and hence jobs. Too much hot water, and rising inflation will eat away at people's spending power. The aim is to find the perfect temperature, where employment is as high as it can be while inflation stays subdued.
But as Jerome Powell, the chairman of the Federal Reserve, reminded his listeners in a speech in Jackson Hole, Wyo., on Aug. 24, no one knows what that perfect temperature is. Policymakers must make their best guess of what "full employment" looks like, or when the "output gap" (the difference between where the economy is and its long-run potential) is zero.
Inflation and employment are affected by temporary shocks and structural shifts, as well as by economic policy. Errors take time to show up. It is as if the rate-setters must adjust the flow of hot and cold water not only without knowing what temperature is most comfortable, but also without knowing how hot the bath is to begin with — or when they will be getting in.
Estimates have changed
Over time, those best guesses have changed.
Six years ago, the central estimate among members of the Federal Open Market Committee (FOMC), the body that sets interest rates, was that in the long run, unemployment would settle at 5.6 percent. Now their estimate is 4.5 percent. Weak productivity growth has led them to cut their estimate of the United States' long-run growth rate, too, from 2.5 percent in 2012 to 1.9 percent.
Whether they were right to do so is the subject of much debate. Some economists think policymakers have been too quick to conclude that dismal growth after the financial crisis indicates a new normal. A recent paper suggests that the standard ways of estimating an economy's potential are overly influenced by blips in its performance. Others think that running the economy hot could spur productivity-enhancing innovation, as wage growth forces firms to economize on labor. Skeptics of that argument point out that the productivity slowdown started before the crisis, suggesting that it is unrelated to labor-market conditions.
As the Federal Reserve's mandate refers to employment, not output, members of the FOMC must consider a narrower question: what does full employment look like? Here, the puzzle of the past few years has been why, even as the unemployment rate has plunged, inflation has been so stubbornly low. Hawks think that hidden inflationary pressures are building; doves, that behind that headline unemployment rate there is still excess labor capacity.
Until very recently, the doves have had the best of the argument. The most obvious interpretation of such a low unemployment rate is that the labor market could not improve much without pressing prices upward. However, it has been soaking up not only job seekers, but also people who reported that they had not been looking for work, or who had been working fewer hours than they wanted.
But arguing that the labor market still has hidden slack is becoming harder. Data released on Sept. 11 revealed that Americans are quitting their jobs at the highest rate since 2001. For each job opening, there are just 0.82 hires and 0.9 unemployed people hunting for a slot. All of the main measures of labor underutilization reported by the Bureau of Labor Statistics are at or below their pre-crisis trough, and near to where they were at the peak of the dot-com boom.
It is possible that still more people will be drawn into the labor market. The prime-age employment rate in August was 79.3 percent, a little below the pre-crisis peak of 80.3 percent and below the high of the past 70 years, of 81.9 percent. But those benchmarks may no longer be appropriate: male labor-force participation has been drifting downward for decades.
Setting the tap at neutral
Recent data have also favored the hawks. Headline inflation has been above target for five months. Inflation excluding food and energy prices, generally regarded as more useful than the headline figure when it comes to predictions, is rising. It hit 2 percent for the first time since 2012 in July.
Olivier Blanchard of the Peterson Institute for International Economics points out that over recent decades, inflation has become less influenced by the jobless rate, and is therefore less useful as a signal of whether the economy has hit full employment. Nevertheless, he sees enough evidence from the labor market to conclude that the economy is very close to full employment, and predicts an end to all the head scratching.
One way to interpret the recent trends is as a vindication of the FOMC's approach to interest rates. As the economy seems to be heating up, they are twisting the bath tap to what they think is a neutral position. So far, they have managed not to overdo it.
Some have called for faster action, fearing a repeat of the 1970s, during which inflation, and inflation expectations, rose in a mutually reinforcing spiral. But as Powell pointed out in his speech, although inflation has recently moved up to near 2 percent, there are no clear signs of an acceleration above that.