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Analysis: Time for Fed to accept that U.S. growth not what it used to be?

An eagle tops the U.S. Federal Reserve building's facade in Washington, July 31, 2013. REUTERS/Jonathan Ernst
An eagle tops the U.S. Federal Reserve building's facade in Washington, July 31, 2013. REUTERS/Jonathan Ernst

By Jonathan Spicer and Ann Saphir

NEW YORK/SAN FRANCISCO (Reuters) - Year after year Federal Reserve policymakers have clung to a belief that the U.S. economy will soon regain its pre-recession stride. And year after year they have been wrong.

Now a growing number of economists and at least one top Fed official think Americans should lower their expectations.

They argue gross domestic product is more likely to grow at a 2 percent annual rate, rather than 3 percent or more, given the retirement of baby boomers and the extent to which the Great Recession discouraged workers and badly damaged industries such as finance and construction.

If they are right, the heyday of booming U.S. productivity might have passed, and the central bank's aggressive monetary policies may be misdirected and possibly even harmful. If the Fed keeps policy too easy for this more muted economy, it could lead to runaway inflation and asset bubbles.

In the five years since the depths of the financial crisis, the Fed has slashed interest rates to near zero and bought more than $3.8 trillion of bonds to spur consumer and business credit and a recovery in employment and economic growth.

"This sense that real GDP growth is going to pick up soon - I'm very skeptical about that," Jeffrey Lacker, president of the Richmond Federal Reserve Bank, said earlier this month, citing among other things consumers' apprehension about the effects of another deep recession.

"I know it's a popular forecast, but I'm skeptical," said Lacker, who has long opposed the Fed's very easy policies. "I see 2 percent growth ahead."

Most of his colleagues at the central bank disagree.

As of September, the Fed's policy-setting Federal Open Market Committee expected about 3 percent GDP growth next year, and up to 3.5 percent in 2015 as the economy tries to make up for ground lost in the 2007-2009 recession. A string of business activity gauges have beaten expectations recently, providing some evidence of a strengthening outlook over the near term.

"We are seeing continuing positive signs about momentum going forward," John Williams, the president of the San Francisco Fed and a policy centrist, told reporters last week.

But throughout the slow recovery, the Fed has consistently proven to be overly optimistic, regularly ratcheting down forecasts, which even then have been much higher than reality.

In early 2010, for instance, it forecast that GDP would rise 3.5 percent to 4.5 percent in 2012; by early 2012, the forecast was cut to 2.2 percent to 2.7 percent. Ultimately, the economy grew just 2 percent.

Many economists at the Fed and elsewhere believe a series of headwinds -- from Europe's debt crisis to sharply tighter fiscal policy in Washington -- has prevented as robust a recovery as they had hoped.

Most Fed officials expect the economy to pick up as the latest fiscal drag fades, before settling back as the recovery matures to the 2.2 percent to 2.5 percent range they see as sustainable over the long haul.

"Our hope is that the improvement in real GDP growth that many forecasters had expected to be in progress by now will soon begin and ... provide sustained improvement in labor markets," Boston Fed President Eric Rosengren said last week.

In this view, which remains the consensus, many workers who lost their jobs in recent years will ultimately find employment. More jobs mean more income, which in turn means more spending.

In addition, U.S. households have gone a long way in whittling down their debts and domestic energy output is surging, curbing America's dependence on imports and lowering business costs -- two big reasons for optimism.

Even so, the optimists themselves have grown a bit gun shy. "I've seen this movie before," Dennis Lockhart, the Atlanta Fed chief, said at an economic forum in Montgomery, Alabama, on Tuesday.

THE UNEMPLOYMENT PUZZLE

Fed Chairman Ben Bernanke has been peppered with questions on why the central bank has missed the mark time and again.

At a September news conference, he said the economy's potential growth rate has "slowed somewhat, at least temporarily" due to the crisis and recession, acknowledging that the Fed failed to predict a slowdown in labor productivity.

Productivity and the growth of the workforce determine an economy's potential. Growth in the U.S. labor force averaged 1.6 percent from 1970 to 2010, but dropped to just 0.9 percent last year. The Congressional Budget Office expects the rate to decline to 0.4 percent by the 2020s as baby boomers retire.

It is harder to know what is behind the slowdown in productivity growth, though economists generally point to lower investment in high-tech capital and research and development.

Since 2005, non-farm productivity growth has dropped a full percentage point to 1.9 percent; economists at JPMorgan expect it to eventually hit 1.5 percent. Given the shrinking workforce, they think the economy's long-run growth potential has slipped to about 1.75 percent -- the lowest in the post-war era.

The Fed's muscular monetary policy has aimed to deliver growth of 3 percent or more. That is the pace commonly considered necessary to significantly ratchet down unemployment.

But on this front, too, the Fed has been surprised.

The October unemployment rate of 7.3 percent is down from a post-recession high of 10 percent in 2009 -- all while GDP growth averaged only about 2.3 percent.

Weak payroll growth, despite a speedy drop in joblessness, forced Bernanke in September to backtrack from a June statement in which he said the Fed expected to halt its bond-buying by mid-2014, when joblessness would be around 7 percent.

But some economists argue easier policy is not the answer given the economy's shifting fortunes.

"Easy money will likely lead to asset bubbles or higher inflation, because policy is miscalibrated relative to ... the economy's underlying potential," said Joseph LaVorgna, chief U.S. economist at Deutsche Bank.

He said potential GDP growth had "meaningfully downshifted" and warned of "potentially serious negative long-run implications" of current monetary policy.

In this view, the U.S. labor market was dealt a long-term blow by the recession and financial crisis.

Booms in finance and construction hiring helped boost growth before the 2007-09 recession. But those sectors have since lagged, undercutting the economy and raising questions over whether they will ever fully bounce back.

Further, the percentage of working-age Americans who either have a job or are looking for one reached a 35-year low in October, suggesting lasting pessimism about job prospects.

"I'm in the camp that the damage done to the U.S. economy was much larger than most people think," said Bluford Putnam, chief economist at futures exchange operator CME Group and a former economist at the New York Federal Reserve Bank.

"Unless Washington does everything right -- and that's just not going to happen -- the U.S. is a 2 percent economy now."

(Reporting by Jonathan Spicer and Ann Saphir; Editing by Leslie Adler)

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