No Second Thoughts: Sustained 3.5% Growth Is Unlikely

Nov. 01, 2017 3:22 AM ETSPY, QQQ, DIA, SH, IWM, TZA, SSO, TNA, VOO, SDS, IVV, SPXU, TQQQ, UPRO, PSQ, SPXL, UWM, RSP, SPXS, SQQQ, QID, DOG, QLD, DXD, UDOW, RWL-OLD, SDOW, VFINX, URTY, EPS, TWM, SCHX, VV, RWM, DDM, SRTY, VTWO, QQEW, QQQE, FEX, ILCB, SPLX, EEH, EQL, SFLA-OLD, SPSM, QQXT, SPUU, IWL, FWDD, SYE, SBUS, SMLL, SPXE, PPLC, PPSC, UDPIX, JHML, OTPIX, RYARX, SPXN, USSD, HUSV, RYRSX, SCAP, SPDN, SPXT, SPXV, USWD4 Comments

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Editor's note: This article was originally published on October 31, 2017, by Menzie Chinn here.

Reader Arthurian writes in the wake of the 3% growth rate (SAAR) reported for 2017Q3:

Back in January Menzie Chinn said he thought growth in the 3.5-4% range was "unlikely". I wonder if he is having second thoughts now.

I'm going to show two pictures deploying at most undergraduate statistics to show why I - like most numerically literate people - still think sustained 3.5% growth is unlikely.

First, consider what a naive statistical model - an ARIMA(1,1,1) estimated over the 1986-2017Q3 period - says, as compared to a 3.5% or 4% growth rate.

Figure 1: Reported GDP (blue), ARIMA(1,1,1) dynamic forecast (red) and 64% prediction interval (gray lines), implied path for 3.5% sustained growth (pink) and for 4% (light green), all billions Ch.2009$ SAAR. Source: BEA 2017Q3 advance release, author's calculations.

Note that by estimating the regression starting in 1986 when the trend growth rate was relatively high, I am slanting the results toward projecting faster growth. Even then, the 3.5% growth rate is at the uppermost edge of the 64% prediction interval. 4% growth is even more laughable.

Second, now consider what sustained 3.5% growth implies for the output gap. For that calculation, one needs an estimate of potential GDP; for want of a better measure, I use CBO's estimate. This is shown in Figure 2.

Figure 2: Reported GDP (blue), implied path for 3.5% sustained growth (pink) and potential GDP, all billions Ch.2009$ SAAR. Source: BEA 2017Q3 advance release, CBO (June 2017), author's calculations.

Assuming sustained 3.5% growth, the output gap by end-2019 would be 4.2%, 5.9% by end-2020. Of course, CBO could be terribly misguided about the trajectory of potential GDP. But in order to believe potential GDP can grow at 3.5%, I really do believe that it can only be done by adherence to Spaceology. Refer to Figure 3, reproduced from my January post, and look at what the orange bar - labor productivity - has to do in order to hit 3.5% potential growth.

Figure 3: Contributions to annual growth in potential GDP growth, from labor force augmentation (blue bar), and from labor productivity growth (orange bar). DJT's target of 3.5-4% shown as pink range. Source: CBO, Budget and Economic Outlook, January 24, 2017, Table 2-3; and Trump-Pence website

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James D. Hamilton has been a professor in the Economics Department at the University of California at San Diego since 1992. He served as department chair from 1999-2002, and has also taught at Harvard University and the University of Virginia. He received a Ph.D. in economics from the University of California at Berkeley in 1983. Professor Hamilton has published articles on a wide range of topics including econometrics, business cycles, monetary policy, and energy markets. His graduate textbook on time series analysis has over 14,000 scholarly citations and has been translated into Chinese, Japanese, and Italian. Academic honors include election as a Fellow of the Econometric Society and Research Associate with the National Bureau of Economic Research. He has been a visiting scholar at the Federal Reserve Board in Washington, DC, as well as the Federal Reserve Banks of Atlanta, Boston, New York, Richmond, and San Francisco. He has also been a consultant for the National Academy of Sciences, Commodity Futures Trading Commission and the European Central Bank and has testified before the United States Congress. _________________________________________________ Menzie D. Chinn is Professor of Public Affairs and Economics at the University of Wisconsin’s Robert M. La Follette School of Public Affairs. His research is focused on international finance and macroeconomics. He is currently a co-editor of the Journal of International Money and Finance, and an associate editor of the Journal of Money, Credit and Banking, and was formerly an associate editor at the Journal of International Economics and the Review of International Economics. In 2000-2001, Professor Chinn served as Senior Staff Economist for International Finance on the President’s Council of Economic Advisers. He is currently a Research Fellow in the International Finance and Macroeconomics Program of the National Bureau of Economic Research, and has been a visiting scholar at the International Monetary Fund, the Congressional Budget Office, the Federal Reserve Board and the European Central Bank. He currently serves on the CBO Panel of Economic Advisers. With Jeffry Frieden, he is coauthor of Lost Decades: The Making of America’s Debt Crisis and the Long Recovery (2011, W.W. Norton). He is also a contributor to Econbrowser, a weblog on macroeconomic issues. Prior to his appointment at the University of Wisconsin–Madison in 2003, Professor Chinn taught at the University of California, Santa Cruz. He received his doctorate in Economics from the University of California, Berkeley, and his AB from Harvard University.

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