The most difficult problems facing the U.S. economy are physical constraints to the noninflationary growth of its demand, output and employment.

Those physical constraints are the stock and quality of human and (physical) capital. They are also called factors of production which determine the boundaries of potential economic growth under conditions of stable prices.

Here is an example: The potential growth of the U.S. economy in 2022 and 2021 was officially estimated at 1.6%. But the actual average growth rate of 4.1% during those two years exceeded nearly three times the economy’s physical limits to growth.

The result was an accelerating consumer price inflation to 8% in 2022 from 4.7% in 2021. And that was not just because inflation was driven by soaring energy and food costs. Taking energy and food out of the U.S. consumer price index, the core inflation was rising 5.7% in 2022 and 5.5% in 2021, showing that increasing inflation was reflecting excessive demand.

A costly return to price stability

Consider the difference: the core inflation in 2020 was only 1.6% because at that time the aggregate demand in the U.S. had been falling at an annual rate of 2.8%.

Now, what is the U.S. to do with its runaway inflation?

The answer is simple: Washington will have to correct its past errors of extravagant credit creation with rising interest rates until signs can be seen that inflation is returning toward an area – around 2% -- designated as the medium-term objective of price stability.

What’s the problem with that?

That policy will push the economy into a recession of ex-ante unknowable amplitude and duration because rising interest rates will be maintained well past the point where the economy can stabilize inflation by balancing the forces of demand and supply.

The issue here is that the monetary policy operates under visual navigation; it has no instruments like radars that can detect subsonic missiles.

Central banks also don’t know exactly where the economy is at the time of a policy change – and they know even less where the economy will be when the lagged impact of the policy change begins to hit demand and employment.

All that is well known to students of monetary theory, who are commonly derided by politically inclined economic activists as “know nothing theorists.”

None of that offers a reliable operational guidance: Monetarists want fixed rules of money supply management, while economic activists want to tinker with a complex branch of public policy affecting the livelihoods of entire nations.

So, what do we do here?

We must go back to basics that we know something about. For example, we have reasonably good standards of measuring the labor force. And we also know how to divide the gross domestic product (GDP) by the labor force.

Build a better structure of U.S. economy

That will give us two important economic variables. One is the active civilian labor force, and the other is the amount of output per unit of labor input – which is called labor productivity.

There we have most of what we need. Adding the rate of growth of the labor force and the rate of growth of labor productivity will provide an excellent guess of the economy’s growth potential – i.e., a growth rate with stable prices.

Here is what that gives for the U.S. economy. During the period of 2010 and (including) 2022, labor force and productivity grew at respective average annual rates of 0.5% and 1%.

Adding those two numbers, we get a potential U.S. economic growth of 1.5%.

And that unfortunately shows a serious deterioration in the structure of the U.S. economy. During the ten-year period of 1997 to 2007 the potential growth was rounded off at 3% on labor force growth of 1.2% and a productivity growth of 2%.

What that says is that tinkering with monetary and fiscal policies by economic activists to boost growth around election cycles will only lead to boom-bust rounds that will return the actual economic growth within limits consistent with productivity and labor force.

And that’s exactly what happened during 1997-2007: the GDP growth came in at 3.1% for a growth potential of 3%. We are observing the same trend for the period of 2010-2022 as the average actual growth of 2% is declining toward the potential growth of 1.5%.

The policy message is clear: If we want a stable and sustainably higher U.S. economic growth, those 100 million Americans currently out of the labor force should become employable again. And we must invest more in education, science and technology to significantly upgrade labor productivity.