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Why More Stimulus Can Do Only So Much for the U.S. Economy

Productive capacity, not stimulus, is what drives the economy’s long-term potential GDP.

We’ve taken an upbeat view on the U.S. economy, projecting U.S. real GDP growth of 5.3% in 2021 and 4% in 2022. We even forecast GDP to surpass our pre-COVID-19 expectation by 2022. We think the economy will be ready for liftoff following the arrival of herd immunity with mass vaccination in mid-2021 in the United States. In particular, normalization of consumer behavior will mean a snapback of consumer services, driving an overall GDP recovery (including a full recovery in the job market).

Yet the new $1.9 trillion COVID-19 relief package, which President Joe Biden signed into law March 11, has led some forecasters to become even more optimistic than we are, projecting as much as 200 basis points more GDP growth through 2022. Thanks greatly to massive stimulus, we agree that the U.S. economy is set to test its limits in a way that hasn't been done since before the Great Recession.

The key question is where that upper limit is. Answering that question means determining the level of potential GDP, representing the economy’s productive capacity.

What Drives Economic Growth?

To start, we lay out a basic framework for how to understand GDP and its relationship to potential GDP.

GDP is equal to the level where aggregate demand and aggregate supply are the same (in other words, in equilibrium).

  • Aggregate demand is the total amount of goods and services that are purchased. This reflects the appetite for spending among the entities that shape the economy, as well as the influence of fiscal and monetary policy.
  • Aggregate supply (short and long run), or the total amount of goods and services that firms are selling, reflects the production side of the economy.

In the short run, aggregate supply is flexible. This means that an increase in aggregate demand can temporarily cause GDP to increase.

In the long run, however, aggregate supply is inflexible and set at the level of potential GDP. Potential GDP is the long-run productive capacity of the economy (when workers and capital are fully employed). The difference between current GDP and potential GDP is referred to as the output gap.

If the economy is operating below potential GDP--if there is an output gap--then fiscal stimulus can be vital to the economy. This means there is slack in the economy, such as when unemployment is high and lots of factories are sitting idle. The chart above illustrates such a scenario. Fiscal stimulus acts by boosting aggregate demand, which pushes GDP higher until it reaches potential GDP.

However, fiscal stimulus can’t push GDP sustainably higher than its potential level. There is some ability to run higher than potential in the short run, but this causes the economy to overheat, resulting in higher inflation. GDP ultimately settles back down to its potential level.

Potential GDP is shown in the chart as a vertical line. This means that potential GDP is inflexible with respect to the level of aggregate demand. Therefore, if fiscal stimulus boosts aggregate demand, this has no effect on the long-run equilibrium for GDP. Potential GDP is driven by supply-side factors such as labor force growth or technological progress, which largely aren’t affected by fiscal stimulus.

How High Is U.S. Potential GDP?

Unfortunately, no one knows exactly where potential GDP is for the U.S. (or any economy, for that matter). Potential GDP is a latent variable, meaning that it cannot be measured directly, only inferred. Typically, economists assume that the economy is operating at potential if inflation is low and stable, but there are no signs of large excess capacity in the economy, such as high unemployment.

The premier authority on potential GDP is the Congressional Budget Office. In the chart below, we show our U.S. real GDP forecast compared with the CBO's estimate of potential GDP. Our forecast runs about 1.5% above the CBO potential by 2025. This wouldn't be sustainable if potential GDP were truly at this level. However, we think that the CBO's projection is probably too conservative and that potential GDP in 2025 will be about at the level of our GDP forecast (that is, about zero output gap).

How do our forecasts compare?

  • Our disagreement with the CBO mostly hinges on where potential GDP was in 2019 before the pandemic. We don't agree that the U.S. was operating above potential in 2019, as there were virtually zero signs of overheating in the economy. In fact, inflation (as measured by the core personal consumption expenditure deflator) was just 1.7%, below the Federal Reserve's 2% target. We think that the U.S. was still operating slightly below potential GDP in 2019.
  • We agree with the CBO when it comes to its conservative projection of potential GDP growth (including 1.9% growth from 2021 to 2025). In particular, we agree that labor productivity growth is more likely to resemble the mediocre 2000s to 2010s rather than the heady 1990s. We think the slowdown in productivity growth has been due to secular trends in technology, something that stimulus doesn’t have much ability to change.

Because we think that potential GDP growth is likely to be low, we're skeptical of the more bullish GDP forecasts that have been issued in response to the 2021 fiscal stimulus legislation. But a word of warning: It is notoriously difficult to forecast potential GDP. This is illustrated in the chart below, showing the CBO's forecast revisions in the decade following the Great Recession.

The CBO was blindsided by the persistent drop-off in GDP after the recession. At first it nudged down its potential GDP estimates slightly, expecting the economy to eventually catch back up, though it never did. The CBO only gradually lowered its potential GDP forecast, recognizing this new normal.

The CBO was hardly alone among forecasters in getting caught off-guard by potential GDP. Given the difficulty of forecasting potential GDP, there's substantial uncertainty around our views on the matter. It's quite possible that the CBO's conservative projection is correct--and alternatively, there's significant upside risk to our GDP forecast if the economy's productive capacity is much higher.

Inflation Surprise Is Possible if Stimulus Overheats Economy

Many investors are now anticipating a potential inflation surprise to the upside in coming years, and this has resulted in a surge in market-implied inflation forecasts. The chart below shows the five-year break-even inflation rate, the average inflation rate expected over the next five years based on a comparison of yields on regular U.S. Treasury yields with yields on Treasury Inflation-Protected Securities. The five-year break-even has surged in recent months to 2.4%, a post-Great Recession high.

To some extent, we think this increase in inflation expectations makes sense. We think it’s likely that GDP will reach its potential in the next few years. And as we mentioned above, attempts to push the economy above its potential result in inflation pressures.

Given rising inflation fears, even a few economists traditionally known as supporters of fiscal stimulus have issued concerns about the size of the recent package (notably Larry Summers and Olivier Blanchard). We think these concerns are overblown. As we’ve noted, there’s some chance that potential GDP is a good deal higher than most economists think—in which case the stimulus will be extremely healthy for the economy.

On the other hand, if the economy does temporarily overheat as it pushes up against its potential, we highly doubt that inflation will get out of control. Long-term inflation expectations are well anchored at low levels, and the Federal Reserve should be able to easily tame inflation by hiking interest rates.

To explore more about our economic forecasts and the effect vaccination will have, sign up for our webinar.