Macroeconomic uncertainty is on the rise after the U.S. move to impose steel and aluminum import tariffs. However, assuming we do not see a more protectionist U.S. stance on trade that harms growth prospects, we expect U.S. fiscal stimulus to bump up U.S. growth by about 1 percentage point in 2018.
This growth bump comes just as the economy reaches full capacity and raises the risks of swelling budget deficits and of the U.S. overheating.
Markets have been grappling with these implications. How they further adapt depends crucially on long-run potential growth, a measurement key for gauging the degree of overheating—or how much output is running above full capacity. Potential growth represents the highest speed at which an economy could grow over the long term.
We see two reasons why potential growth may get a rare post-Great Recession upgrade—even if it stays well below pre-crisis estimates, as we write in our Global macro outlook The secular stagnation that never was?
Potential growth may be higher than is widely assumed.
Our work suggests that potential growth downgrades, an annual exercise since the Great Recession, may have gone too far. The snail’s pace of the post-crisis recovery made it harder to separate cyclical from structural forces—and cyclical growth drags during the recovery from the Great Recession were often interpreted as permanent damage.
This means there may be more slack left in the economy than is commonly believed. How much slack could there be? The Stagnation fears in action chart below compares published potential output estimates with a technique developed by Olivier Blanchard and Danny Quah in the late 1980s to better estimate potential growth by cleanly separating transitory and supply-driven shocks. The latter shows a sizable output gap remains: up to 3% in the U.S. and 4% in the eurozone.
We are skeptical the output gap could be that large. Potential growth is not observable and is tricky to gauge in real time: Historically, overheating was underappreciated at this point in past expansions. Still, we believe estimates and perceptions of potential growth may now turn more positive as actual gross domestic product (GDP) picks up and fiscal stimulus kicks in.
A key ingredient of potential growth—productivity—looks poised for a rebound.
Potential growth is determined by labor supply, capital deepening and productivity—and productivity trends are shaped by investment in innovative technology. Yet productivity has not kept pace with solid spending on research and development (R&D), implying pent-up gains that may soon be realized.
U.S. companies have deepened investment into R&D—especially tech—even as the recovery in capital spending has lagged. The current ratio of R&D investment to GDP is 10% above tech-bubble highs. We see this robust technology spending and a budding recovery in business investment translating into revived productivity growth, as temporary factors holding back productivity gains fade.
The implications for markets?
An upward revision to U.S. potential growth could give the expansion a longer lifespan by containing the degree of near-term overheating. Better long-run growth should further lift real yields. Yet equities can still do well: Improved growth should also boost earnings in tandem, while abundant global savings should limit how high yields go.
The positives from fiscal stimulus and potential upgrades to potential growth may be undone by increasing U.S. protectionism, but this is not our base case. We would reassess our view should the rise of protectionism start to upset the long expansion.