Untapped potential: GDP growth in the post-pandemic economy

Summary

The 2008-2009 recession was followed by a slow economic recovery and major downgrades to estimates of U.S. potential GDP growth. As we emerge from the economic damage wrought by COVID-19, will the 2020s be another "lower for longer" period? Or will the post-pandemic economy buck the trend and undergo a renaissance?

Potential GDP growth, or the long-run sustainable run-rate of the economy, is a significant determinant of household income growth, business profit growth, and real interest rates. Potential growth can be broken down into three components: labor, capital, and total factor productivity (i.e., intangible factors that lead to a better combination of capital and labor, like new technology). We believe there are both reasons for optimism and pessimism regarding the outlook for potential GDP growth in the 2020s.

• For the optimists: (Upside Case)
  Labor: Remote work facilitates both higher participation and more hours worked; the robust policy response and rapid rebound in output limits labor market scarring; new policies improve structural child care challenges and lift participation.
  Capital: Government investment rises up off the mat following the federal infrastructure deal and state & local governments' overflowing coffers; an already impressive performance in private investment over the past 18 months continues amid efforts to make supply chains more resilient.
  Productivity: Remote work generates better matching between employers and employees; recent tech advancements have become more widely adopted; the tight labor market of recent years leads to more investment in new technologies.

• For the pessimists: (Downside Case)
  Labor: Damage to the labor force cuts deeply due to retirements and shifts in industry activity; new policies aimed at supporting families underwhelm, stymied by capacity; waning boost from immigration.
  Capital: Higher corporate taxes dampen private investment; federal infrastructure deal generates only a very small boost to growth.
  Productivity: Work from home is a one-time boost affecting only a slice of the workforce; pandemic learning-loss dents future human capital; productivity inflection points are hard to forecast–best to assume status quo in the meantime.

We lean toward the upside case. The 2010s illustrated that workers will respond to persistently strong labor demand, and remote work and policy support to families further raise the prospect for somewhat faster growth in hours worked. Even if higher corporate taxes come to pass, the investment seems likely to grow faster than in the past cycle given a tight labor market and greater public investment spending. Productivity growth was already trending higher pre-pandemic, and mere mean reversion could supply a noticeable lift to potential growth. We estimate potential growth through the end of the decade to be around 2.2%–stronger than the 2010s and current estimates from the FOMC and CBO.

The magnitude of our upgrade to potential GDP is relatively small, but the direction is meaningful. Small changes over long periods of time can compound, pointing to a higher level of output and income at the end of the decade. While the global savings glut should continue to put significant downward pressure on long-term rates, stronger potential GDP growth along with structurally higher inflation suggest that revisions to the neutral rate of interest may not always be downward. We believe long-term interest rates are headed higher in the years ahead even if they remain relatively low by historical standards. 

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