Is Economy nearing Natural Limit?

Unemployment dropped to 6.1% in June and down to 6.2% for the 2nd quarter. Unemployment is dropping faster than many economists expected. I would explain the fast drop as a reaction by firms to maintain their profit rates as labor share and productivity are both stationary now.

The recent drops in unemployment are evidence that the economy is reaching its natural limit. At which point inflation would want to rise and employment would saturate the needs of firms. Yet, we don’t see wage growth yet which will hinder inflation. So we are likely to see more drops in unemployment if wage growth remains low.


For 2nd quarter 2014, I project that the UT index, which measures spare capacity between real GDP to effective demand, will be between 0% and 0.8%. A UT index between 0% and 1% signals that the economy is close to its natural limit.

UT index = effective labor share – TFUR
TFUR = capacity utilization * (1 – unemployment rate)

Projected numbers for 2nd quarter 2014…

UT index = 74.5% – (79% * 93.8%)
UT index = 74.5% – 74.1%
UT index = 0.4%

The UT index was 0.6% in 4thQ13 and 0.9% in 1stQ14. So the economy will have been near its natural limit for 3 quarters. Here are 3 things that reflect being close to the natural limit.

  1. The recent drops in unemployment
  2. The recent uptick in inflation (yet inflation will be held back by stagnant wage growth)
  3. The unusually strong contraction of real GDP in 1st Q 2014.

We may see real GDP grow slower over the next few quarters than people expect. Let’s recall that GDI (gross domestic income) started moving sideways in early 2006… almost 2 years before the recession. So recognizing lots of optimism out there, output growth could slow down from here. It has happened before.

gdi before crisis

Note: The UT index dropped below 1% in the 2nd quarter of 2006 and the ensuing stagnation of GDI were both signs that the economy had reached its natural limit in early 2006.

We also see that Janet Yellen mentioned pockets of increased risk-taking, which are apt to occur as the economy passes its natural limit. The Fed would normally want to tighten monetary policy so as to avoid growing financial instability from “excessive” risk-taking.

It seems the economy is nearing its natural limit. If so, we will see growing pressure on the Fed to think about tightening earlier.