The Big Idea
Stephen Stanley | November 3, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The pandemic seriously muddied the waters around long-term economic trends. As time passes, the distortions created by the lockdowns imposed in 2020 and 2021 move further into the rear view mirror and the changes in the structure of the global economy that resulted from or were accelerated by the pandemic take hold. We are reaching a point when it may be possible to begin to assess where the economy’s potential and equilibrium interest rates are going to settle out.
The pre-pandemic benchmark
Coming out of the pandemic, the economy is likely to be structured differently from the pre-pandemic period. The 2010s experience was shaped in many ways by the Global Financial Crisis. Investors sought the safety of high-quality liquid assets, mostly by preference but in the case of financial institutions because of new stringent regulations. US inflation was persistently below 2% even as economic growth was solid and labor markets became historically tight late in the decade.
At the end of 2019, the FOMC estimated that the longer-run parameters for the economy were 1.9% for real GDP growth, 2% inflation (the Fed’s target), 4.1% for the equilibrium unemployment rate, and 2.5% for the neutral fed funds rate. Real interest rates were thought to be persistently low, and the 10-year Treasury yield ended 2019 well below 2%.
How has the economy changed?
Just over two years since the economy reopened, several broad new themes have emerged. There are doubtless many more, but I will focus on three.
- Demographics, and
- Remote work
First, in a reversal of a trend that prevailed for 20 to 30 years, the economy is deglobalizing. This appears to reflect two factors. The first is logistical. One of the shockers of the pandemic period was the vulnerability of far-flung supply chains. In response to the disruptions seen in 2020 and 2021, large international companies have cut the length of their supply chains. We have seen a boom of construction of manufacturing and warehousing facilities in the US as firms bring their operations closer to home. The second reason is geopolitical. Tensions have risen between China and the West and between Russia and the West. The result has been a decline in global trade.
A second change in the U.S. economy is that demographics are shifting. This has little to do with the pandemic and results more from the passage of time. For the first two decades of this century, the large Baby Boomer cohorts were mostly working and saving heavily for their eventual retirements. By now, however, a rising proportion of this age group has retired. That means a higher and higher percentage of the population is consuming but not producing and is also drawing down savings to support themselves.
Third, the pandemic ushered in the acceptance of working remotely, and a significant portion of the population liked working from home enough to insist on continuing to do so, at least a day or two per week, well after lockdowns ended. The ways in which employers and employees as well as businesses and consumers interact were also forced to adapt in 2020, and at least some of those innovations are likely to prove persistent.
Long-term implications for the economy
How will these changes affect the long-run performance of the economy? Starting with deglobalization, this is a negative supply shock for the global economy. If firms no longer locate their operations to achieve the lowest cost production, then by definition, input costs will be higher, and inflation should follow. This is a trade-off that many American firms appear willing to accept, in some cases for pure business reasons and, at times, for geopolitical or security reasons (for example, boosting domestic semiconductor output capacity). The clear implication is that the US and global economies will, at the margin, experience higher inflation. To the extent that central banks aim to enforce 2% targets, they would, all else equal, need higher policy rates to hit their target.
There will also be winners and losers around the world from deglobalization. The biggest winner is probably the US because the American economy ran the largest trade deficit prior to the pandemic. As noted above, the shift toward domestic production has already sparked a construction boom to create new manufacturing and warehousing capacity, and the dividend for US growth is likely to persist as domestic output in certain industries ramps up. The losers would be those countries that were most geared toward exports. The economic underperformance of China and Germany over the past year or so almost certainly stems to a significant degree from the contraction in global trade.
The aging of the Baby Boomers will likely have two primary impacts on the US economy. First, labor markets should be tighter over time, as the labor force participation rate declines over time. At the margin, firms will have to pay up for workers. This trend can be offset, of course, by an acceleration in immigration. Indeed, that appears to be the case over the past year or so, as a flood of migrants has entered the country, though it remains to be seen if the status quo on immigration is politically sustainable. Second, as retired Baby Boomers begin drawing down their nest eggs, the balance between savings and investment shifts in a way that would skew toward higher interest rates to clear the market. It should be noted that deglobalization could also push in this direction, since China tends to recycle most of the dollars it earns by exporting goods into the US into investments rather than purchasing goods and services from the US. In other words, a smaller US trade deficit with China means less Chinese buying in the US Treasury and other asset markets.
The economic implications of work from home is still ambiguous. In some industries, the elimination of commuting times and the freedom to work from home may raise productivity while in others, the loss of collaboration and more difficult communication could reduce it.
Where does that leave us?
Starting with the trend or potential of real GDP growth, a simple formulation is that the long-run trend in real growth is the sum of underlying productivity gains and labor force growth. The pre-pandemic consensus was that trend productivity growth was likely somewhere in the 1% to 1.5% range—the average from 2011 through 2019 was 1.2%—and that labor force growth, dragged down by the demographic trend discussed above, was somewhere in the neighborhood of 0.5% per year.
The average rate of productivity growth since the beginning of 2020 has been about 1.5%, so we may be stabilizing not far from where we started. At the moment, the increase in the working-age population has accelerated from about 0.5% to 1%, presumably due to heavy immigration, but it is not clear that this can be sustained.
Depending on how things play out as the remaining dust settles, it appears that the long-run potential for the economy may be around 2%, with the possibility of some upside potential, a little higher than the FOMC’s latest estimate of 1.8% but not radically different.
Unlike potential growth, which the Fed has little or no control over, the central bank is presumed to have complete say over the long-run inflation rate. So, the variable in play here is not so much inflation, but the equilibrium policy rate. With labor markets likely to be running hotter at the margin due to demographics and with global firms’ cost bases rising faster due to deglobalization, it seems pretty clear that the FOMC is going to have to work harder to keep inflation down at 2% than it did in the 2010s. In other words, the equilibrium policy rate is most likely higher than it was prior to the pandemic.
It is important to note that the post-Global Financial Crisis period was an anomalous time. From the 1960s until the GFC, a rule of thumb that worked pretty well over time was that 10-year Treasury yields should average about the same as nominal GDP growth, and the fed funds rate tended to be about 50 bp lower, reflecting a typical term premium.
That framework crumbled for various reasons after the GFC, when real interest rates ran at or below 0% for years on end without sparking inflation. However, if the relationship returns to normal, then, in the current context, we would sum 2% real growth and 2% inflation and come up with a 4% 10-year Treasury yield and a 3.50% neutral fed funds rate. Relative to those equilibrium levels, rates would be expected to be higher when the economy is strong and the Fed needs to run a restrictive policy, such as now, and lower when the economy is weak and the Fed needs to stimulate growth.
FOMC members do not appear to have seriously considered these forces just yet. The median FOMC estimate of the longer-run funds rate has been stuck at 2.50% since before the pandemic began. Several officials have acknowledged in recent months that the neutral rate may have risen, but the dots would suggest that most of them have not yet begun to seriously engage yet on this question. That makes sense, as the committee does not have an urgent need to pin down the level of neutrality when policy is clearly restrictive and likely to remain so for an extended period. My own estimate of a neutral funds rate is in the 3% to 3.5% range, not far from the result derived from the old rule of thumb.
Interestingly, in contrast to the Fed, financial market participants have to mark themselves to market at all times on these questions, and distant fed funds and SOFR futures are currently running at or above 4%, suggesting that investors may be entertaining an even higher neutral funds rate than my rough estimate. This is quite a turnaround, considering that in early 2022, just before the FOMC began raising rates, the consensus view embedded in these futures was that policy rates would never exceed 2%!