I. Key Macro Theme: Supply Becomes Relevant Again
Insufficient demand has been the binding constraint on growth ever since the global financial crisis erupted more than eight years ago. That is slowly changing. Output gaps1 have declined across the major economies (Chart 1). It would be nice to say that this was the result of accelerating demand growth. It wasn't. The sad truth is that demand growth has been rather lackluster. Rather, the erosion in spare capacity has mainly come from exceptionally weak supply growth (Chart 2). As we argue below, understanding the nature of the supply-side slowdown is critical for gauging the outlook for financial markets.
Part 1: The Curious Case Of The Shrinking Output Gap
An economy's supply-side potential is a function of productivity (output-per-hour) and labor inputs (total hours worked). Both have been decelerating over time.
Let's start with productivity. Chart 3 shows that productivity growth has fallen across almost all countries and regions. One way to account for the drop in productivity growth is to deny it ever happened. A number of commentators have argued that the data published by various governmental statistical agencies greatly understates productivity gains. If that were the case, it would imply that GDP growth has also been underestimated.
Human capital accumulation has also slowed both in the U.S. and elsewhere, dragging productivity growth down with it. Chart 7 shows that globally, the fraction of adults with a secondary degree or higher is increasing at half the rate that it did in the 1990s. In and of itself, this is not alarming, as it mainly reflects the significant progress that has already been made in improving educational access around the world. However, on a rate-of-change basis, it does suggest that the tailwind to productivity growth from rising educational enrollment is fading.
As with productivity growth, there is some debate about how much of the slowdown in labor force growth is due to structural factors and how much is due to cyclical ones.
No one would dispute that much of the decline in labor force growth simply reflects the fact that the working-age population is expanding more slowly in most countries (Chart 11).
Part 2: From Deflation To Inflation
Is the slowdown in productivity and labor force growth inflationary or deflationary? The answer is "both." Slower potential GDP growth is deflationary at first, but becomes inflationary later on.