CFE Analysis

Recovery, Expansion, and an Old Normal Yield Curve

In December of 2019, the U.S. unemployment rate stood at 3.6% and prime age labor force participation, at 82.9%, was at an 11 year high. Today, December 2020 jobs figures were released, with unemployment at 6.7% and participation at 81%, both making it clear that today’s economic backdrop is bleak. These data also make clear that engineering an extended period of strong growth is highly justifiable. We also learned this week that, quite improbably based on historical precedent, not one but two Georgia special Senate elections were won by Democrats. With the same party now (just about) in charge in the House, Senate and White House, big fiscal thrust and a strong recovery/expansion, have a good chance of coming into view over the years directly ahead.

Why insist on fiscal policy as the instrument to engineer above trend growth? In the past four decades, the neutral real short-term interest rate, or r-star, has fallen dramatically, and probably below zero. As a consequence, and amid low inflation, the US has been at or near the zero lower bound on nominal short-term interest rates ever since 2008. In the 1990-91 and 2001 recessions, the Fed cut the funds rate by about 5 percentage points. Nothing of that sort in response to an adverse shock was possible, at we entered 2020. And the shock of the COVID-19 virus, of course, was unprecedented in modern times. Global activity fell by more than 15%, February through April of last year. 

The Fed, of course, collapsed the fed funds rate and resumed and expanded the scope of unconventional monetary policy. In addition, and more importantly, enormous fiscal rescue was almost immediately delivered. But even with all this, we enter 2021 with major slack in labor markets—much bigger than the U3 jobless rate suggests. The Fed can do little more. As policy makers behind closed doors acknowledge, if the goal is to pursue faster growth, fiscal policy is the only serious game in town. Some caution that the level of government debt severely limits the size of any fiscal stimulus. We have objected to that view, for the past several years. Fears of ‘too big a public debt’ are wildly exaggerated. We made that case, in the aftermath of the Trump tax cuts, pointing out that while the justification for the cuts seemed quite flimsy, the stories of dastardly debt related consequences stemming from the cuts simply didn’t hold up to historical scrutiny. That does not make us Modern Monetary Theorists. The MMT crowd touted the room for a fiscally led boom in 2019, with the jobless rate at 3.5%. We found that wildly optimistic, based upon micro principles notions—the debt expansion caused us little angst, but the room to boom from a 3.5% jobless rate? Where were all those extra workers going to come from? 

Now, however, resource slack is large. Thus, the room to boom is in place. And, lucky, lucky, we don’t need to commission bridges to nowhere. We can rebuild falling down bridges nearly everywhere. Throw in a rediscovered American governmental commitment to renewable energy and a fiscal policy to do list rapidly appears. 

How much room is there to boom? In the table below, we project US working age population through 2024Q4. We also project the total labor force, assuming that participation by age cohort returns to 2019Q4 levels. This allows for labor force recovery, while accounting for the aging of the population. Finally, we work out the employment growth that would be required to ensure that U3 jobless rate has returned to 3.5% by 2024Q4. It turns out that this would require 4 years of jobs growth averaging 2% per year. Marry that to 2% labor productivity and roughly a 4% real growth rate for the economy comes into view. 

Would this serve as a reasonable baseline forecast? Up until late Tuesday night, assuming little chance Georgia Dems would go two for two, we have been saying that the likelihood of a fiscal policy engineered boom approached the odds that the New York Jets would win the 2021 Super Bowl. And yet, here we are. Room to grow well above trend rates for a substantial period. And for at least two years, policy levers are largely controlled by one party. 

A long-run underlying problem for the economy is the low level of r-star. But if a very expansionary fiscal policy is sustained, then this should boost materially boost r-star. Moreover, if investors, as strong expansion persists, become less worried about Japan-style stagnation and more worried about inflation, then the term premium, a post War fixture that the last decade erased, might rise somewhat too. Whether from higher neutral rates and/or a higher term premium, a big fiscal expansion has the potential to drive up the ten-year Treasury yield a good bit, although not back to the level of the 1990s.

Indeed, news of the surprise wins of both Democratic candidates in Georgia on Tuesday night caused the ten-year yield to jump about 10 basis points on Tuesday night to a bit above 1%. But with a fiscal expansion capable of delivering several years of growth averaging 4%, we would expect long rates to move a good bit higher, even with the Fed keeping overnight interest rates at zero. This would be especially true if, as we expect, the stronger economy leads the Fed to wind down its purchases of long-term Treasury securities later this year.

Clearly, the secular decline in r-star is a global phenomenon, but it’s partial reversal might be too. COVID has pushed Europe toward big fiscal stimulus. The exit of the ever-recalcitrant United Kingdom may have helped smooth this process along. And, although Germany is suspicious of a European fiscal union, they also love Green energy. EU Green energy plans are now offering big subsidies to decarbonize the economy—a willingness to finance such efforts with public euros may be the final nail in the coffin for ‘expansionary austerity’ notions. Additionally, there is a government financed boom in China. A global shift to more expansionary fiscal policies is a backdrop that might well support a rise for U.S. long rates. 

A rise to, say 2.5%, for U.S. 10-year rates, over the next two years will likely generate much hand wringing—aha, the growing debt burden is fostering our next crisis. This would be coming mostly from those who want a debt crisis for the goal of shrinking government. But in reality a 10-year rate at 2.5%, reflecting sustained rapid real growth, would be good news. It would simply be confirming that such a backdrop, increasingly to investors, appears to be a durable phenomenon. 

Working Age Population261.1m269.6m0.8%
Labor Force Participation Rate61.5%62.1%0.2%
Labor Force160.6m167.4m1.0%
Unemployed (level)10.8m5.9m
Unemployment rate6.7%3.5%
Employed149.8m 161.5m1.9%