A Primer On Potential Growth And Neutral Rates

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by: Evariste Lefeuvre


The Great Recession and some structural factors have harmed potential GDP growth in the U.S.

Yet, the strong growth rates registered in the 1990s and 2000s were inflated by private leverage.

I propose an estimate of future GDP growth rate in the U.S. and conclude that there is no reason for the Fed to target a "new neutral" rate of 0%.

The potential growth for the U.S. economy has never been close to 3.5-4%, except for during the period when the investment surge characterized the "wonderful years" of the New Economy. But after the 2001 crash, potential GDP already stood closer to 2.5% than 3.5%. The only novelty by then was the surge in private debt, hence the growing discrepancy between observed growth and what we show in the chart below: GDP growth at a constant debt-to-GDP ratio. As can be seen below, in the 2003/2007 period, GDP was constantly 1 point above its stable-debt level.

The deleverage process after 2008 is also clearly visible with GDP growth hovering below the constant debt-to-GDP implied growth.

Therefore, if there was ever anything like a 3.5-4% GDP target for U.S. GDP growth, it was:

i. For a very short span of time in the mid-1990s; or

ii. Mostly an illusion linked to the surge in private debt.

Potential growth is not based on past averages but on a very simple rule of thumb: the sum of population growth and average productivity gains. We can clearly distinguish four periods.

i. (A) This is the end of the post WW2 boom: falling productivity gain (which came along with higher inflation) and a deceleration in the growth rate of the population.

ii. (B) A period when computers were "everywhere but in the productivity statistics" (Solow paradox - see full quote below*).

iii. (C) The "new economy" when a surge in new technology investment and a growing share of computer production within the manufacturing sector increased the capital per capita and overall labor productivity.

iv. (D) A new era of relatively weak productivity gain where "big data and Apps are everywhere but in the productivity statistics" (Millennial's paradox).

There is currently a huge debate on the future of productivity/technical progress. Brynjolfsson and McAfee are confident in the "bounty" of new technologies but are afraid of the "spread" (inequality, technological unemployment). Gordon makes a list of six headwinds that should bring growth down to 0.5% per year as a maximum in the future.

Based on the template mentioned above I can draw a few conclusions for growth:

  1. Barring a surge in immigration/fertility rates (+) or a war (-), the U.S. population should grow in a range of 0.7/1.0% over the next decade. This is half a percentage point below the level of the 1990s and clearly a negative indicator for the future of U.S. growth.
    1. The fall in the participation rate would have a negative but temporary impact on GDP growth but once stabilized, the only factor that matter for growth is population trend (the level of the participation rate matters a lot for the future level of GDP per head);
    2. A fall in population growth can be compensated by an increase in education, but the increase in tuition price and the lack of genuine schooling reform suggests that educational attainment will not provide significant support to growth anytime soon.
  1. So far, productivity has failed to reach the levels registered between 1995 and 2006 but:
    1. Those levels were reached at a time of "jobless recovery" which suggests that it was partly explained by changes in the management of the workforce than investment in productive capital;
    1. Today's levels compare to the 80s and early 1990, which is a period when growth was decent without the help of debt leverage.
    1. This post is too short to develop a full theory or view on the future of technological progress but we should acknowledge that there is a huge uncertainty about the impact on growth of the IT-induced changes in non-manufacturing activity and their widespread use among the population.

Now we can do the math:

Economic theory is not very helpful in setting the "correct" level of interest rates. In particular, there is never any indication on the maturity of the equilibrium rate. In addition, the rule is generally asymptotic, which means that it should hold at the "steady state" only. The most frequently used approach is the so-called Golden Rule: the interest rate (yield of capital that is, for purists, the marginal productivity of capital) that maximizes consumption at the "steady state" is equal to the sum of population and technical progress.

I assume a 0.7% growth for the population and a conservative growth of 1.25% for productivity gains (below the 1985/2013 average) for the skeptics. This makes a potential growth of roughly 1.75% in the future. If inflation target is 2%, then the Fed may rightly target 3.75% (or slightly above the sum of both).

Bottom Line: the economic world has changed. Public debts limit the scope of action for fiscal policy. Monetary policies are constrained by the zero bound. Non-financial corporate businesses are net savers. The combination of a dwindling population growth rate and faltering technical progress has reduced the potential for GDP growth in the medium run. Yet, even though there might be a risk of secular stagnation through the excess saving of corporates, the data seen above would just suggest a lower average growth in the future but not a stagnation.

There is thus no sound reason for a 0% target for real Fed Funds. If the Fed considers that future inflation will be closer to 1% than 2% in the future it may adjust the target for Fed Funds downward. But if it is correct, real Fed Funds would remain unchanged.

Lastly, the last two episodes when the U.S. repo rate stood far below nominal GDP growth came along with some asset price bubbles (see chart below). Hence, the risk of targeting a 0% real Fed Funds is associated with the risk of more asset price bubbles.

I would agree with the Fed that accommodation might be required for a long time when a long-lasting recession impacts the supply side of the economy, but I would reject a sharp downward revision of real Fed Funds target even if my estimate for potential real GDP growth is well below that of the previous decades.

*1987 New York Times Book Review article: "...what everyone feels to have been a technological revolution, a drastic change in our productive lives, has been accompanied everywhere, including Japan, by a slowing-down of productivity growth, not by a step up. You can see the computer age everywhere but in the productivity statistics."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.