Another way to look at the question of how high interest rates should be is to ask what the growth potential of the economy is. A very simple approach: GDP = the amount of stuff (physical or intellectual) the economy can produce = number of workers x the amount of stuff each worker can make (i.e., productivity). Since we’re interested in maximum sustainable GDP growth, we only need to know the rates of change in the two variables, not the actual amounts.

(Note: rising productivity doesn’t imply somehow compelling people to work harder. It means the country/companies investing in improved tools and equipment, and better education.)

For the working population, the calculation is easy–or at least it was pre-pandemic. On average, the workforce in the US has been growing at about 1.5% yearly, more or less evenly divided between domestic growth and immigration. Over the dozen years ending in 2019, productivity rose by another 1.5% (a drop from the 2.4% of the prior two decades). Together, these imply a real growth rate for the domestic economy of about 3% annually.

The Trump administration’s ban on immigration and imposition of tariffs probably clipped a percentage point from that GDP figure. The pandemic, the failure of the CDC to act, Trump’s pandemic denial, all conspired to reduce domestic population growth (births – deaths) from one million+ to about 250,000 in the twelve months ending last July. Meanwhile, yearly immigration shrank from 1.2 million or so to fewer than 150,000.

Making projections in such a messy time is risky. And to a considerable degree the current situation feels a lot like Japan circa 1990, which was the start of what’s now 32 years of economic stagnation. So it’s not clear how big a bounce back, if any, the economy will have once we put more distance between ourselves and the pandemic.

external shocks

The main thing is that they normally gradually fade away, both because new supply appears and because consumers find substitutes.

The pandemic is the more important one, I think, both for its negative effect on the domestic economy and the interruption of the flow of raw materials, including metals and semiconductors, and finished goods from Asia. To my mind, this shock is starting to abate.

But the Russian invasion of Ukraine has caused a second shock, a spike in global price of oil and gas, as well as of grains like wheat.

I have three thoughts about energy:

–the long-term effect of $100+ a barrel oil will be to speed the changeover to renewables–to EVs in particular. Given that the oil price reacts sharply to small changes in supply/demand, whenever the price peaks it will be followed in short order by a sharp decline

–the US illustrated during the 1970s, by going down that road, that the only really bad reaction to an oil shock is to prevent the higher prices from being passed on to consumers and having them adjust. We’re doing a little of the same today, but nothing like the epic disaster created by Democratic-driven legislation

–natural gas goes its own way, mostly, I think, because its distribution requires elaborate, and expensive, investment in plant and equipment. It’s not the headline grabber that oil is, so it’s arguably less important for the mood on Wall Street.

I’m not keen to take a stand on which way prices will go in the short term, but my experience is that shocks tend to get less shocky, not more, as time passes.

growth rate and interest rate

To return to the point about growth, ex shocks, and as things stand now in the US, the long-term domestic economic growth rate is somewhere around 2%.