Economic Analysis What s happening with U.S. potential GDP growth? Kan Chen Capital stock, labor, and productivity do not show a significant increase following the recent fiscal stimulus According to our forecast, potential output will grow 1.8% per year on average for the next 10 years Potential GDP growth reached its peak in 2017, and thus monetary policy normalization is adequate Ten years ago this month, the collapse of Lehman Brothers marked one of the most traumatic events of the Great Recession. One thing that distinguished this economic downturn from previous ones was its extraordinary persistence. As post-crisis growth kept failing to fulfill expectations, it was clear that this recession was more of a shift in the trend than a disturbance in the cycle. In fact, some economists re-introduced the idea of secular stagnation and suggested that slow output growth could be the new normal. 1 The continually downward revision of potential output projection by the CBO illustrates such increasingly pessimistic opinions toward the productive capacity of the economy (Figure 1). Figure 1. Historical revisions in CBO s estimates of potential output Index, 4Q2007=100 130 125 120 115 110 105 100 95 90 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Source: CBO, ALFRED & BBVA Research 2008 2010 2012 2014 2016 2018 Policy and business decision-making substantially relies on the identification of trend and cycle, and thus the potential output forecasts. On the one hand, if the potential output trend declines significantly due to the permanently damaged capacity during a recession, the economy has likely reached its peak. If that were the case currently, the high GDP growth rate during the second quarter (4.2%) would imply an unsustainable sugar high that would need to be remedied by more restrictive monetary policies. On the other hand, an over-estimated negative impact on potential output would produce a false alarm on the risks of economic overheating and cause over-tightening of monetary policy. 1: Summers, L. H. (2014). US economic prospects: Secular stagnation, hysteresis, and the zero lower bound. Business Economics, 49(2), 65-73. U.S. Economic Watch - 26 September 2018 1
In fact, some economists recently argued that the central bank should slowdown interest rate normalization and even stick with expansionary policies, as the economy may still be below its potential. 2 In this brief, we will analyze potential GDP based on the methodology illustrated in Figure 2. As the flow-chart shows, potential output is based on the extraction and projection of the trends in capital, labor, and productivity. We also demonstrate the estimation and implication of each factor. Figure 2. Methodology to estimate potential output Cobb-Douglas Production Function Labor (total hours) Total Factor Productivity Capital stock Extract structural components Working age Par. rate Labor force Potential NAIRU Hours Solow residual (trend) Potential labor supply Source: BBVA Research Potential Output Capital In light of the recent fiscal stimulus (tax cuts and spending bill), investment is expected to increase, which in turn should boost total capital and thus potential output. In one of our previous analysis, we found that the fiscal stimulus will significantly increase GDP growth between 2018 and 2020, through channels of higher consumption, investment, and government spending (Figure 3). While fiscal policies have a favorable effect on the economy in the short-run, one key question facing us is whether they can also help to build up capital stock in the long-run and lift the trend of potential output. As we learned from previous episodes of fiscal expansions, timing is essential. 3 However, due to relatively high asset prices and crowd-out effects in the booming period, the fiscal stimulus generally has a negligible impact on private investment and thus capital stock. As we can see from Figure 4, the lukewarm response of investment in 2018 confirms that the fiscal stimulus may not be significantly boosting capital stock in the long run. According to our estimation, capital stock will growth at an annual average rate of 2.3% between 2018 and 2028, which is lower than the pre-crisis average between 1997 and 2007 (3.0%), but higher than the post-crisis average between 2011 and 2017 (1.4%). 2: Coibion, O., Gorodnichenko, Y., & Ulate, M. (2017). The cyclical sensitivity in estimates of potential output (No. w23580). National Bureau of Economic Research. 3: Auerbach, A. J., & Gorodnichenko, Y. (2017). Fiscal stimulus and fiscal sustainability (No. w23789). National Bureau of Economic Research. U.S. Economic Watch - 26 September 2018 2
Figure 3. Output growth forecasts SAAR % Figure 4. Investment growth SAAR, % 3.0 40 35 2.5 30 2.0 25 20 1.5 15 10 1.0 5 0.5 0-5 0.0 2018 2019 2020 2021 Baseline No Fiscal Stimulus -10 2010 - Q1 2010 - Q3 2011 - Q1 2011 - Q3 2012 - Q1 2012 - Q3 2013 - Q1 2013 - Q3 2014 - Q1 2014 - Q3 2015 - Q1 2015 - Q3 2016 - Q1 2016 - Q3 2017 - Q1 2017 - Q3 2018 - Q1 Source: BBVA Research Source: BEA, Haver and BBVA Research Labor As we have shown in Figure 2, the quantity of labor is jointly decided by population, labor force participation rate, the natural rate of unemployment (NAIRU), and average hours per worker. As we have discussed in previous outlooks, 4 population aging will significantly affect population growth and labor force participation rates, as other developed economies have experienced during the last couple of decades. Therefore, both growth rates will continue to slowdown in the next decade (Figures 5 and 6). Figure 5. U.S. population %, million 1.8% 1.6% 1.4% 1.2% 1.0% 0.8% 400 300 Figure 6. Labor force participation rate % 67 66 65 64 63 0.6% 200 0.4% 0.2% 0.0% 100 1960 1980 2000 2020 2040 Total, right Growth rate, left Source: BLS 62 61 60 59 1978-1987 1988-1997 1998-2007 2008-2017 2018-2028 Source: BLS, Haver, and BBVA Research 4: For more detailed discussion on the US demographics and labor force participation rate, please refer to the specific chapters in our previous US Outlooks (demographics, labor force participation rate). U.S. Economic Watch - 26 September 2018 3
Besides population growth and labor force participation rate, the natural rate of unemployment and average working hours also point to slower growth of labor. As we can see from Figure 7, although the natural rate of unemployment has an overall decreasing trend, our model indicates that it will stay above 4.5% for the next 10 years. Moreover, due to increasing labor productivity and higher quality of leisure, the average weekly working hours have steadily declined from 37 in 1948 to 32 in 2017 (Figure 8), and the trend is unlikely to reverse. According to our estimation, the average growth rate of labor input will be 0.5% between 2018 and 2028, 0.6% lower than the pre-crisis average of 1.1% between 1990 and 2006. Figure 7. Unemployment rates % 10 Figure 8. Average weekly working hours Hrs. 37 9 8 7 6 5 36 35 34 33 4 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 32 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020 2024 2028 Natural rate of unemployment Source: CBO, BLS, and Haver Unemployment Actual Source: BLS, Haver, and BBVA Research Trend with forecasts Productivity The last factor that determines potential output is potential productivity, which is the trend of total factor productivity (TFP). While the recent development of artificial intelligence and automation has promised to liberate the labor force from tedious low-to-medium-skilled jobs, the majority of statistics have not shown any signs that such scenario is materializing anytime soon. As we can see from Figure 9, total factor productivity (TFP) does not exhibit signs of higher growth. In our baseline forecast, the productivity growth rate will be 0.65% between 2018 and 2028, which is slightly lower than the post-crisis average of 0.72%. In other words, the impact of recent technological innovations will not be much different than those experienced in the past. U.S. Economic Watch - 26 September 2018 4
Figure 9. Total factor productivity growth % 3 Figure 9. Actual and potential real GDP Billion chained 2012$ 23000 22000 2 21000 20000 19000 1 18000 17000 16000 0 1985 1992 1999 2006 2013 2020 2027 Actual Trend Average (2009-2016) Source: BBVA Research 15000 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 Actual Potential (BBVA) Potential (CBO, 2018) Source: BLS, Haver, and BBVA Research Potential output Based on our forecasts of capital stock, labor force participation, average weekly working hours, and total factor productivity, we obtained our estimates for potential output. In addition, we assume that the output gap (the difference between actual and potential output) is approximately zero in 2007. This assumption is consistent with most recent economic statistics, including the output gap series produced by the CBO. According to our estimation, the average growth rate of potential GDP for the next 10 years is 1.8%. That is, because of the aging of the population, moderate growth of capital stock, and moderate productivity growth, the economy will be unlikely to achieve the growth rate before the Great Recession. Considering that most of this slowdown is driven by weaker demographics, even stronger growth in capital stock and TFP would not be able to reverse this trend. In fact, our estimations are similar to those from the CBO, suggesting that policymakers have to take bold actions to improve labor market fundamentals, including immigration policy, labor mobility, education and training, among others. Bottom line In this brief, we estimated the potential output growth for the next 10 years based on the knowledge of capital, labor, and productivity. From a monetary policy perspective, on the one hand, as the output gap is close to zero, the gradually raising interest rates approach 5 by the Fed seems to be the most sensible policy based on our understanding of the current state of the economy. On the other hand, it is worth noting that the recession probability has been rising since early this year, 6 and thus an overly hawkish Fed may unintentionally put the system into risk. As Agustín Carstens, the general manager of the Bank for International Settlement commented at the most recent Jackson Hole Symposium in August, It is a very narrow path to get it right. It is not easy to engineer this normalization process and at the same time to preserve financial stability. The central banks will have to be very careful. 5: https://www.usatoday.com/story/money/2018/07/17/powell-says-fed-plans-continue-ti-lift-interest-rates-gradually/789135002/ 6: For our latest recession probability forecast with a detailed discussion, please visit: https://www.bbvaresearch.com/en/publicaciones/u-s-just-what-the-doctor-ordered-real-time-recession-forecasts/ U.S. Economic Watch - 26 September 2018 5
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