Chapter I: The United States Economy

Overview

While the United States economy has now fully recovered by almost every measure from the sharp recession that was driven by the COVID-19 pandemic, a new wave of significant uncertainty has emerged that has the potential to trigger new recession. The cornerstone of this new wave of uncertainty surrounds inflation. The US is currently observing rates of inflation of around 8 percent on an annual basis, a rate that has not been observed since the early 1980s.

This rapid inflation is being driven by at least four factors: First, global supply chain constraints continue to linger after the pandemic, driving up prices for goods that are in short supply, such as automobiles. Second, widespread workforce shortages emerged during the pandemic as many men and women left the labor force. These workforce shortages lead to more aggressive wage increases to attract workers to fill job openings, and these wage increases typically filter through to higher prices. It is difficult to predict when either of these challenges will subside.

Third, energy prices have skyrocketed in 2022, due to several factors—one being Russia’s invasion of Ukraine. High energy prices not only have a direct impact on overall inflation, but filter through to increase the price of goods and services more broadly due to higher production and transportation costs. Finally, overall demand in the economy has been strong, in part due to aggressive fiscal and monetary policy stimulus measures over the past two years.

This high rate of inflation would undoubtedly create great long-term damage to the US economy if left unchecked, as observed in the US in the 1970s and in many other countries over time. Returning inflation to a modest and stable position is and should be a top priority for economic policymakers. As such, the Federal Reserve has worked very aggressively over the course of 2022 to raise interest rates to suppress overall demand in the economy and therefore reduce inflation. Indeed, the speed at which the Fed has increased rates this year has been as aggressive as ever observed over a short period of time. The fast pace of interest rate increases is partly because the Fed was slow to begin the cycle of interest rate increases due to lingering concerns over new coronavirus variants and outbreaks that continued until early-2022, as well as the unanticipated rapid increases in energy prices in 2022.

Overall, much of the great uncertainty facing the US economy currently stems from the interaction between inflation and these interest rates increases. Indeed, our baseline expectation is that the US economy will follow a path of very slow, albeit positive, economic growth over the next five years overall. In other words, we believe it is possible that the interest rate increases can be timed appropriately such that a broad recession does not develop, and inflation returns to a rate that is considered acceptable (around 2 percent).

However, a strong probability exists that the interest rate increases will prove to be too detrimental to economic growth and would likely tip the economy into at least a moderate broad recession within the next year.

In this chapter we: a) explore recent trends in the United States economy; b) provide a forecast of how the US economy is likely to evolve over the coming five years; and c) explore several major challenges that have the potential to threaten the long-run US economic outlook.

Recent Trends and Intermediate-Term Economic Outlook

GDP As illustrated in Figure 1.1, economic output, as measured by real Gross Domestic Product (GDP), fell dramatically in early 2020 due to the outbreak of the COVID-19 global pandemic. Likewise, GDP growth was strong as the economy emerged from the pandemic. Over the course of 2022, in contrast, GDP growth has weakened considerably, and though year-over-year growth rates have remained in positive territory, annualized GDP growth rates that are typically quoted in news media (not shown) have now been negative for the first two quarters of 2022 (according to preliminary data). While these outright declines in GDP constitute a recession by the traditional definition and would typically raise serious concerns that the US economy will soon be in a full recession, the quarter-to-quarter declines in real GDP have been concentrated in a few sectors, such as housing, auto sales and federal government spending.

PRODUCTIVITY Worker productivity, as measured by output per hour worked, is the fundamental driver of economic prosperity over the long run. For instance, very high levels of productivity fundamentally explain why nations such as the US and UK enjoy high standards of living while very low levels of productivity explain why nations such as Haiti and Zimbabwe suffer extremely low standards of living. In Figure 1.2 we illustrate the intermediate-run growth in productivity in the US over the last two decades or so. As illustrated, productivity growth has been low by historic standards since 2013. Despite a brief rise around the COVID-19 recession, productivity growth is expected to remain below the 30-year average, and the questions of why this has occurred and how to reverse it are hotly debated among economists and policymakers.

GOVERNMENT SPENDING The recent evolution of government spending in the US is reported in Figure 1.3. Total federal, state, and local government spending, which amounts to approximately one-third of US GDP, rose significantly during the COVID-19 recession due to a large increase in transfers and several stimulus measures. Over the course of 2022, in contrast, federal government spending has fallen significantly as the labor market has strengthened and many of these federal pandemic relief measures have expired. Reductions in government spending create a headwind for overall economic growth in the short term.

EMPLOYMENT As depicted in Figure 1.4, the US labor market was strong prior to the pandemic, and in fact was growing at levels that exceed what economists generally perceive as the maximum level of jobs the economy can sustain over the long run (also referred to as “full employment”). Over the course of the initial onset of the COVID-19 pandemic, nearly 25 million people in the US lost their jobs. While the US labor market cannot be strictly defined as that of as a “V-shaped recovery,” the rebound in payrolls over the last year or so has been strong and the labor market is at or close to its pre-pandemic level, depending on which measure of employment is examined. Overall, the national economy again is at or near its full employment level.

UNEMPLOYMENT Turning to the unemployment situation, the national unemployment rate stood at a low of 3.6 percent just before the beginning of the COVID-19 recession, as noted in Figure 1.5. This was one of the lowest jobless rates experienced since the beginning of modern economic statistics. The unemployment rate skyrocketed at an unprecedented pace, reaching a peak of nearly 15 percent in the Spring of 2020. However, the jobless rate fell rapidly as pandemic-driven lockdowns ended in 2020 and has continued to improve since as hiring activity has remained consistently strong for much of the last 16 months or so. Currently the rate stands near a historic low in the mid-three percent range.

Another important statistic is the share of all unemployed persons who have endured long unemployment spells, which is typically defined as 27 weeks or more. As illustrated, this figure has fluctuated widely over the course of the COVID recession and recovery in an understandable way. As the labor market has strengthened over the past two years, the figure is now roughly equivalent to its pre-COVID level.

There are two common criticisms associated with the conventional unemployment rate reported in Figure 1.5. The first is that the figure does not account for workers who can only find part-time work but who would prefer a full-time opportunity, often referred to as “under-employed.” The second relates to discouraged workers. Here, the idea is that if one is looking for work for an extended period and is ultimately unsuccessful at landing a job, the individual may become discouraged and quit looking for work altogether. When this happens, the person is no longer counted as “unemployed” or part of the labor force at all by the conventional measure, since the conventional measure only considers people who are actively looking for work. For both reasons, the conventional unemployment rate understates the overall severity of the unemployment situation.

In Figure 1.6 we report the conventional unemployment rate (referred to as U-3) along with a measure that also includes discouraged workers and individuals who are only able to find part-time work due to economic reasons (U-6). It is important to note that these criticisms are legitimate and that what many would consider to be “true” unemployment is higher than the conventional statistic indicates. However, it is also important to note that the movement of the two figures over time is quite consistent and despite their level differences, the unemployment situation has improved demonstrably in recent years until the COVID-19 pandemic, regardless of which metric is used.

LABOR FORCE PARTICIPATION The labor force participation rate is a complementary measure to the unemployment rate. The labor force participation rate captures the share of the adult population that would like to work—termed “in the labor force”—while the unemployment rate captures the share of the labor force that is unable to find employment at any given moment in time. Ultimately, the labor force participation rate is a more fundamental descriptor of an economy’s long-run employment situation.

In Figure 1.7 we report labor force participation for the US since the early 1980s. As illustrated, the figure peaked around 2000 at 67 percent, fell substantially after 2008, and then maintained stability up until early-2020. The broad evolution of this figure is largely driven by demographic processes, namely the emergence and aging of “Baby Boom” generation. The figure began to rise substantially around 1965, when the first of the “Baby Boomers” were nearing 20 years old. This measure continued to rise through the late 1990s, when the first of this group turned 55 years old, but then began to decline substantially around 2008—the point when the leading edge of the Baby Boom approached conventional retirement age.

In addition to the baby-boomer effect, the post-WWII structural change in labor force participation rates was driven in large part by meaningful gains in the female labor force that occurred through the mid-1990s.

Labor force participation once again fell substantially because of the COVID-19 recession, as “discouraged workers” left the labor force, reaching a low of just over 60 percent. Immediately after the lockdowns, the figure begun to improve, recovering to over 62 percent. However, the figure is still about one percentage point below its pre-COVID level, due primarily to a slower recovery in labor force participation among workers in older age groups (i.e. 55 and older).

Overall, the declines in labor force participation likely present an impediment to the nation’s long-run economic growth potential as fewer workers will be available to support retirees vis-à-vis private pension plans as well as Social Security and other federal programs. Furthermore, many economic challenges below might interact with a lower rate of labor force participation in the long run, leading to a significantly different performance for the US economy over the long term.

UNEMPLOYMENT INSURANCE CLAIMS Following up on our discussion of unemployment, in Figure 1.8 we report the number of initial unemployment insurance each week nationally. As illustrated, the figure was very stable at around 200 thousand leading into the COVID-19 pandemic. The figure skyrocketed to over five million in an extremely short period of time through March and April of 2020. After dramatic improvement over the second half of 2020, the figure fell to its pre-pandemic level in the spring of 2022 and has increased only slightly.

HOUSING STARTS Housing starts are often an important signal of movements in economic activity. In Figure 1.9 we report housing starts for the nation. As illustrated, housing starts suffered noticeably during the COVID-19 recession, but then bounced back in 2021, in large part due to extremely low interest rates, large increases in household savings and pent-up consumer demand. Over the course of 2022, however, the level of single-family starts has declined significantly in recent months due to a major erosion in affordability caused by significant increases in mortgage rates and high house prices. This is an important early indicator that the recent interest rates increases have had a major impact on one major segment of the economy that is negatively affecting broader US economic activity.

CONSUMER CONFIDENCE Recessions typically have a catalyst in some exogenous shock (such as the bursting of a housing bubble or high oil prices) but falling consumer sentiment is often the key driver of demand during recessions. Typically, the initial recession catalyst reduces demand directly, and thereby output. This drop in output reduces confidence, which reduces demand further, and a vicious cycle ensues. On the upswing of the business cycle, an economic system is unlikely to achieve its full potential until confidence is restored. 

As reported in Figure 1.10, US consumer confidence fell markedly in early-2020 in response to the COVID-19 pandemic. The figure showed some noticeable improvement over the course of 2021. However, the figure has fallen dramatically over the course of 2022 and is near historic lows currently, driven largely by high gasoline prices, high overall inflation, and other factors such as the massive volatility in equity markets and Russia’s invasion of Ukraine. Low consumer confidence is a crucial measure currently and is an important factor in determining the probability of a new recession.

Economic Outlook

GDP OUTLOOK As described above, economic forecasting is especially difficult currently given the situation that the nation faces with regards to inflation and rising interest rates. As illustrated in Figure 1.11, our forecast calls for a very slow rate of growth over the next two years, with a gradual return to a more typical rate of growth later in the outlook period. However, we do not expect a return to a rate of growth that equals the 30-year average over the outlook period.

EMPLOYMENT / UNEMPLOYMENT OUTLOOK Our employment outlook is illustrated in Figure 1.12. The forecast calls for employment to continue to grow at a modest pace over the outlook period. However, this is subject to a higher-than-average level of uncertainty, as discussed above. In Figure 1.13 we present the forecast for the unemployment rate. The forecast calls for a gradual increase in the rate over the next two years, returning the figure close to its natural rate of around 5 percent. This expected increase in the unemployment rate will largely be driven by entry into the labor force, rather than by job loss.

Challenges Facing the US Economy

Issues related to the long-run sustainability of the US federal government budget remain a primary concern for long-run economic growth. As such, we explore US federal government budgetary issues through figures 1.14 through 1.16.

FEDERAL GOVERNMENT DEBT As depicted in Figure 1.14, federal debt held by the public, which was consistently below 40 percent of GDP between 2001 and 2008, began rising dramatically in 2008 as tax revenues plunged and the federal government ramped up spending in part to stimulate the weakening economy. This shock placed the figure is in the upper-70-percent range, a rate that is nearly double the average from the prior 30 years. Further, fiscal policy actions in 2019 and aggressive stimulus measures in 2020 and 2021 have increased the figure once again, now to a level close to 100 percent of GDP. This places the figure at its highest level in history in apart from brief episodes during the Civil War, the Great Depression, and World War II. The figure is expected to remain high for the foreseeable future. Further, assuming no changes in public policy, the ratio is forecast to explode in the long run (not shown) given the aging of the US population and the additional public benefits that an older population receives (i.e. Medicare and Social Security).

A public debt level that surpasses a critical level can be detrimental to long-run economic prosperity if the public debt becomes large enough to drive interest rates high enough that they ultimately crowd out private-sector savings and investment activity—a key driver of productivity growth in the long-run. While economists are unsure of what that critical level is, clearly the US is much closer to that level compared to historical norms that existed before the 2008 recession.

TRANSFER PAYMENTS The recent dynamic involving US federal government debt is closely related to the increase in transfer payments from the US federal government. Examples of transfer payments include Social Security, unemployment benefits, welfare benefits, Medicare, and Medicaid. As illustrated in Figure 1.15, transfer payments increased substantially in 2008, reaching a high of around 18.5 percent of personal income, compared to a 30-year average of around 16 percent. Aggressive stimulus efforts surrounding the COVID-19 pandemic have dramatically increased the figure further, placing it at a recent high of 24 percent for 2020. Both waves of increase are attributable to two major factors: a) falling income and rising unemployment during recessions, and b) more generous public policy, such as the extension of unemployment benefits. However, as the economy has recovered since the pandemic began in early-2020, the figure has returned to around 18 percent, a figure that is still noticeably above historic norms.

In Figure 1.16 we report the composition of US federal government spending. As illustrated, mandatory spending, which includes transfer payment programs such as Social Security, Medicare, Medicaid, unemployment insurance, and the like, comprised 75 percent of all federal spending in 2021. Although this figure was boosted by a few percentage points for 2021 due to the lingering effects of the COVID recession and additional federal legislation such as the American Rescue Plan Act, we have observed an important increase over the past 20 years or so and most of this can be attributed to an aging population. At the same time, defense spending and nondefense discretionary spending have fallen correspondingly. If the long-term debt burden is to be reduced, it will have to be accomplished through either higher taxes or a reduction in one of these areas of spending, and each path carries its own set of concerns and difficult political realities.

INFLATION Next, we turn to inflation – perhaps the most significant problem facing the U.S. economy in the short term. As reported in Figure 1.17, inflation has skyrocketed to around 7 to 8 percent on a year-over-year basis in recent months, depending upon which reported measure is used. This is the highest rate of inflation experienced in the US since the early-1980s and comes in sharp contrast to the mostly modest inflation that the US experienced for more than two decades, rarely moving outside of the 1 to 3 percent range—a period in economic history referred to as “The Great Moderation.” This sharp rise in inflation has been driven by at least four factors: a) high energy prices, in part driven by Russia’s invasion of Ukraine; b) continuing global supply-chain constraints that emerged during the COVID pandemic; c) workforce shortages that emerged during the COVID pandemic; and d) strong aggregate demand, in part driven by aggressive federal stimulus, both monetary and fiscal, over the past two years. It is very difficult to predict when the first three factors described will normalize. 

INTEREST RATES This high rate of inflation would undoubtedly create great long-term damage to the US economy if left unchecked, as observed in the US in the 1970s and in many other countries over time. Returning inflation to a modest and stable position is and should be a top priority for economic policymakers. As such, the Fed has worked very aggressively over the course of 2022 to raise interest rates to suppress overall demand in the economy and therefore reduce inflation. Indeed, the speed at which the Fed has increased rates this year has been as aggressive as ever observed over a short period of time. The fast pace of interest rate increases is partly because the Fed was slow to begin the cycle of interest rate increases due to lingering concerns over new COVID variants and outbreaks that continued until early-2022, as well as the unanticipated rapid increases in energy prices in 2022.

Overall, much of the great uncertainty facing the US economy currently stems from the interaction between inflation and these interest rates increases. It is possible that the rate increases can be timed appropriately such that a broad recession does not develop, and inflation returns to a rate that is considered acceptable (around 2 percent). However, a strong probability exists that the interest rate increases will prove too detrimental to economic growth and will ultimately tip the economy into at least a moderate broad recession.

INCOME INEQUALITY The final concern that we consider relates to rising income inequality in the US. In Figure 1.19 we illustrate the share of aggregate income in the US that is earned by households divided into quintiles. As illustrated, the lowest-income quintile, while representing 20 percent of households, earned around 3 percent of the total income in the nation in 2020. The second lowest-income fifth of households earned around 8 of the total income in the nation in 2020, and so on. The highest-income quintile earned over 52 percent of the nation’s total income in 2020. Further, as illustrated, the income share for the highest quintile has risen by nearly 9 percentage points over the period illustrated, corresponding to a decline in the share earned by the other quintiles. 

Overall, many individuals are concerned about the growing income concentration among higher income households and these individuals have often requested or proposed public policies that could reverse this trend. Finding an appropriate public policy response that balances promoting economic growth overall and achieving a socially acceptable income distribution can prove to be challenging in many cases. However, education plays an important factor in explaining the income distribution in the U.S. As reported in Figure 1.20, households where at least one resident holds a bachelor’s degree earn far more than any other group, and the gap between those with a bachelor’s degree and others has risen slightly over time.

We close the chapter by illustrating some facts surrounding race or ethnicity and the economic prosperity by gap in the U.S. In Figure 1.21 we illustrate median income by race or ethnicity. The figure shows stark differences across these race or ethnicity categories. Similarly, in Figure 1.22 we report earnings differences across race or ethnicity groups for those households who hold at least a bachelor’s degree.