Economy Grows in Q3, Exceeding Potential

The Bureau of Economic Analysis (BEA) reported that the economy, as measured by growth in real gross domestic product (GDP), rose by 3.2 percent in the third quarter of 2017. The third estimate of third quarter 2017 GDP growth is slightly less than the 3.3 percent growth rate recorded in the second estimate, but faster than the “advance”, or initial, estimate of 3.0 percent. With this reading, GDP growth has accelerated for two consecutive quarters after decelerating over the second half of 2016. The third quarter of 2017 reading marks the fastest rate of growth since the first quarter of 2015. However, this strong rate of growth is likely not sustainable over a longer period of time.

The figure below shows the contribution to the third quarter of 2017 GDP growth estimate by each major category. Personal consumption expenditures (PCE) accounted for the largest contribution to each estimate of GDP growth. This reflects that PCE represents 70 percent of GDP. As BEA notes in its release, “With this third estimate for the third quarter, personal consumption expenditures increased less than previously estimated, but the general picture of economic growth remains the same.”

A previous post illustrated that the level of actual economic activity has returned to its potential level. The GDP growth rate in the third quarter of 2017 marks the first time since the fourth quarter of 2007, the quarter that the Great Recession officially began, that actual GDP exceeds its potential level. Earlier commentary noted that the Fed typically raises its key interest rate when the “output gap” is converging, actual GDP is returning to its potential level, or when actual GDP exceeds its potential level. The response by the Fed to the output gap is captured by the role that the output gap plays in a basic Taylor Rule.

Potential GDP is estimated by the Congressional Budget Office and represents the “CBO’s estimate of the maximum sustainable output of the economy”. If the levels of potential output represent the “maximum sustainable output of the economy”, then the growth rates implied by these levels are the maximum sustainable growth rates for the economy.

The table above highlights this and other important phenomenon. First, over a longer period of time, the growth of the economy, which averaged 3.5 percent on an annualized basis between 1950 and 2007, just prior to the Great Recession, matched the growth rate of potential GDP over the same period. A large part of the reason why growth over the 57 years ending just prior to the Great Recession exceeds the average annualized growth rates of actual GDP in the years following the recession, 2010-2017, is because the economy’s potential growth rate was higher.

At the same time, the damage to the economy caused by the Great Recession significantly and adversely affected both actual GDP growth, the economy nosedived into a recession, and the growth of the economy’s potential. The average annualized potential growth rate between 2000 and 2007 was 2.8 percent, still lower than growth rates over previous decades, but declined 1.2 percentage points over the Great Recession to 1.6 percent on average over 2008 and 2009.

The growth rate of potential GDP has slowed further in the years since the recession, however, the growth rate of actual GDP since the recession ended has exceeded its rate of potential, 2.1 percent versus 1.4 percent. The faster growth of actual GDP, which partly reflects “accommodative” monetary policy, has allowed actual GDP to return to, and now exceed its potential level. At the same time, and very importantly, the average annualized growth rate of 2.1 percent in the years following the recession was enough to push the actual level of GDP to and above its potential, in part because the growth of the economy’s potential level has decelerated since the 1960s.

Hypothetically, if the actual level of GDP matched its potential level through time, then the growth rate of actual GDP would match the growth of the economy’s potential. While this exactness emerges over longer periods of estimation, quarter to quarter, actual GDP growth typically deviates from its potential growth rate as indicated in the figure above. This chart does confirm that growth in actual GDP that exceeds the potential rate of growth is not sustainable, partly because short-term interest rates typically rise under these conditions in response to Fed rate hikes. Second, periods of recessions, marked by the gray shaded regions, coincide with both declines in GDP and deviations in actual GDP to rates below its potential growth rate.

While the growth rate of potential GDP is not as volatile as the growth rate of actual GDP, it does exhibit some variability. The above table indicates that the average growth rate of potential GDP by decade has been slowing since the 1960s. Most notably, there has been a marked deceleration in the growth rate of potential GDP between the third quarter of 1998 when it reached 4.1 percent, and the fourth quarter of 2010 when it was 0.9 percent.

The CBO does expect the growth rate of potential GDP to accelerate in the coming years. However, it is expected to remain below 2.0 percent, averaging 1.7 percent in 2018 and 1.8 percent in 2019, the longer-run projection of the median FOMC member in the December Summary of Economic Projections. The expected growth rates of potential GDP are less than both the current growth rate in actual GDP and the 1950-2007 average rate of 3.5 percent. Nevertheless, potential GDP is a theoretical construct and is subject to some skepticism. At the same time, recently enacted federal policy could raise the actual GDP growth because it increases the rate of growth in potential GDP.

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