Regaining Potential GDP

Over Econbrowser, we have been debating the nature of potential GDP.  In this post, we look at the potential GDP and the growth path of the US economy under various scenarios.

Actual and potential GDP in the US

Sources: Congressional Budget Office, Bureau of Economic Analysis at VoxEU

Some economists like to use the concept of 'potential GDP', which endeavors to measure the output of the economy at full capacity.  The difference between potential and actual GDP is the output gap.   If this gap is large, then the economy presumably has room to grow at above normal rates.  In addition, under such circumstances, policy makers tend to favor monetary and fiscal policies to stimulate the economy.

Since 2007, observed GDP has consistently under-performed potential GDP ('pGDP'), with no real sign of the gap closing.  As a result, the Congressional Budget Office (CBO) has consistently lowered potential GDP estimates year after year.  For Q4 2014, the CBO estimated potential GDP at $16.9 trillion dollars (2009 dollars), $1.3 trn (-7.0%) below its 2007 pGDP estimates. 

Actual and potential GDP in the US Sources: Congressional Budget Office, Prienga projections

Actual and potential GDP in the US

Sources: Congressional Budget Office, Prienga projections

On the graph above, we again see the CBO's pGDP forecasts from 2007 and 2014, respectively (updated with Q1-Q3 2014 actual GDP data).  As can be seen, the CBO 2014 forecast glides potential GDP to meet actual GDP.  If the mountain won't go to the Mohammed, as the saying goes, then Mohammed will go to the mountain..  And that's just what the CBO has done.  Theory has yielded to reality, and potential GDP has been trimmed to match observed data.

Consequently, no extraordinary GDP growth is expected.  In its 2014 outlook the CBO expects 3.3% GDP growth in 2015 and 2016, with growth falling back to a pedestrian 2.5% by 2017.  Potential GDP growth is anticipated to rise from 1.7% to 2.4% by the end of the forecast period.   Thus, the Feb. 2014 forecast of the CBO takes a fairly grim view of the US economy, with neither actual nor potential GDP growth expected to be anything better than mediocre.

Recent GDP data paints a more optimistic picture.  After a dip in Q1 2014, the US economy enjoyed blistering growth in the second and third quarters, posting 4.6% and 5.0% growth rates, respectively. 

If one uses a supply-constrained oil markets model, then this comes as no surprise.  High oil prices are considered the principal reason for weak US--and indeed, global--GDP growth.  With the collapse of oil prices in the last quarter of 2014--complemented by surging US oil production--this constraint is removed and GDP should recover its earlier trend.  In an earlier post, I noted that airline data suggests that US should recover trend GDP around 2018.

What does this imply? If we assume that the 2007 potential GDP line is still valid, then the US economy would have to grow by 4.9% per annum to close the gap by year-end 2018.  This is a tall order.  It is not easy to find a four year stretch in US history averaging nearly 5% growth.  A 4% growth rate, however, would close about half the gap to the 2007 pGDP line by 2018, consistent with the CBO's 2011 projection of potential GDP.    This seems more plausible, although certainly not lacking in ambition.

In any event, if oil is to blame for weak GDP growth--and we believe that is true--then GDP growth is likely to pick up, and it may accelerate materially.  If so, the last two quarters' growth rates will prove no anomaly, but rather the shape of things to come.