Low Potential?

One of the raging debates among economists and investors these days concerns the size of output gaps in the major developed economies. If output gaps are smaller than widely believed, central banks will need to tighten monetary policy earlier than expected, which could trigger a selloff in equity and bond markets.

The IMF estimates that the output gap will reach 2.2% of potential GDP in advanced economies in 2014, down from a high of 4.9% in 2009.

What is often overlooked is that output gaps would be much larger today had it not been for a significant decline in potential GDP growth. Chart 1 shows the growth of real potential GDP in a variety of countries and regions since 2008. Each panel contains two series: one drawn from the IMF’s April 2008 World Economic Outlook database; the other from the most recent projections released in April 2014. (The IMF did not make output gap projections back in 2008, so I assumed that whatever output gap the IMF estimated for 2008 would eventually converge to zero in 2014; this allowed me to back out projected potential GDP growth).

Low Potential? - Chart 1

The numbers are striking. For advanced economies as a whole, the IMF estimates that real potential GDP will be 7% lower in 2014 than what it projected in 2008. For some countries, the drop in potential GDP growth is immense: for example, the IMF estimates that real potential GDP in Spain will be 21% lower in 2014 than what it had projected in 2008. In the case of the U.K., potential GDP is likely to be 10% lower.

Are these estimates correct? To be sure, potential growth must have slowed over the past six years relative to what the IMF had expected before the crisis. The Great Recession led to a steep drop in capital spending, which sapped productivity. It also undoubtedly caused many people to flee the labor market, some of whom are unlikely to return.

Yet, the sheer magnitude of the downward revisions to potential GDP strikes me as excessive. The weakness in capital spending has likely pushed up the rate of return on capital (this is one reason why profit margins are so high), which should give a nice cyclical boost to capital spending going forward. In addition, a large share of youth who dropped out of the labor market will eventually return (quite a few decided to stay in college, which is not necessarily a bad thing). And perhaps most importantly, many workers who remained in the labor force have ended up in substandard jobs that do not fully utilize their skillsets. Stronger labor demand over the next few years should allow them to transition to jobs where they are more productive, helping to boost potential GDP.

Back in the 1930s, many commentators argued that the economy had suffered a permanent loss of capacity. Yet, as Chart 2 shows, real per capita GDP eventually returned to its pre-Great Depression trend by the 1950s. If this happens again, it would imply that today’s estimates of potential GDP are too low, which is another way of saying that the output gap may be bigger than widely estimated. In that case, tightening too early because of a fear of diminished spare capacity would be a huge mistake (just as it was in 1937).

Low Potential? - Chart 2

I suspect that Janet Yellen is quite sympathetic to this line of thinking, and as such, she will want to see a meaningful burst of inflation before she starts to hike rates. But if the output gap is bigger than commonly believed, as I think is the case, that burst of inflation may not occur for several more years at least. This calls into question the widely-shared view that the Fed will start raising rates next year.

U.S. Employment: Trust The Data

Today’s payroll report, combined with the ISM reports, suggests that the U.S economy is back on track after a weak start to the year.

US Employment - Trust The Data

The labor data and ISM surveys paint a much more upbeat picture than other recent economic releases on the demand side (notably, consumer spending reports). Which is telling the right story? Our bias is that today’s payroll report is a good reflection of the current state of the U.S. economy.

The ISM data is relatively free of revisions, and the BLS payroll data is generally considered to be of higher quality than other official statistics.

At 288 000 monthly payrolls in June, and upward revisions to previous months, the job market is on a decent – albeit not stellar – trajectory. The main positive points in the report are that the employment gains are broad-based across sectors; there were notable gains in “high-quality” jobs such as financial services, and other professional and business services; and the unemployment rate fell on the back of a flat participation rate (i.e. not for structural reasons).

On the latter point, the Fed’s estimate of NAIRU sits at 5.3%. Therefore, with a current unemployment rate of 6.1%, there is still a sizeable gap before the economy hits full employment and sustainable wage inflation takes hold. The Fed is unlikely to feel much pressure to warn of premature rate normalization, but the steady decline in the unemployment rate nonetheless serves as a reminder that the ZIRP era is coming to an end. Stay tuned.