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The latest update from the Congressional Budget Office (CBO) points to a favorable outlook for the US economy over the coming years. The forecasts, which are based on current law and therefore include the sharp spending cuts due in March, suggest that economic activity will slow this year, largely due to fiscal headwinds, but will pick up thereafter. GDP growth is expected to come in at 1.4% in 2013, before rising steadily to 4.4% in 2016 at which point it will have reached capacity. Such an occurrence would imply almost a decade of below-potential output.
As the economy is predicted to perform with substantial slack for the next few years, monetary policy is expected to remain extremely accommodative without necessarily much of an increase in price pressures. Short-term interest rates are not expected to rise until 2016, with ten-year yields expected to drift upward only gradually.
Despite extremely accommodative monetary policy, and a robust rate of economic growth, labour market underutilization is likely to persist for a considerable period of time. The headline unemployment rate is expected to remain broadly stable this year, before falling quite rapidly to its natural rate of just over 5% by 2018. Such an outcome would mark a decade-long unemployment rate of above 6% – the worst such streak since records began. A sustained period of elevated unemployment is thought to erode workers’ skills and permanently reduce potential output. This is a big downside risk for the US economy. In its report, the CBO state that the difficulty for the long-term unemployed to find work ‘will gradually diminish over time but not completely disappear’.
On a more positive note, a growing economy will likely come as a boon to the public coffers. The CBO estimates this year’s deficit will fall to $845 billion, down from $1.1 trillion in 2012. Furthermore, public borrowing is set to decline quite rapidly thereafter – from 7% of GDP last year to 2.4% in 2015 before beginning to rise gradually. Over the forecast horizon, public debt as a share of national income is effective stabilized. Such a scenario may allow politicians to avoid having to impose some of the harsh austerity measures that have been seen in Europe.
Despite a more favourable fiscal outlook, the impact of trillion dollar plus deficits will be felt for a while yet. Net interest payments are expected to rise from around 1.5% of GDP to over 3% within a decade, however, spending in other departments is expected to be more restrained. In particular, defense spending is expected drift downward throughout the forecast horizon. Separately, the CBO has trimmed its expectations for health-related expenditure as a result of recent successes in reducing health-related inflation.
Put all of this together, and there is plenty of reason to be cheerful. Nevertheless, we would do our profession a disservice if we didn’t provide some caveats. Most importantly, the numbers and charts referred to above should be remembered for what they are: forecasts. As such, they are subject to quite of uncertainty and, if anything, the risks are tilted to the downside. The post-crisis recovery has been frustratingly slow, and most economists have been too optimistic about the prospects for a rapid recovery. This meshes with the academic literature that shows recessions associated with financial crises tend to be followed by much more protracted recoveries than is normally the case. In particular, work by Carmen Reinhart and Kenneth Rogoff says that it takes an average of 4.5 years before GDP per capita returns to its pre-crisis peak. The US is set to achieve this feat in the coming year, broadly in-line with Reihnard and Rogoff’s suggested timeframe. Should this achievement herald the end of the post-crisis sluggishness, the US economy should do very well indeed.