Status Update - U.S. Economy on the Mend

U.S. Economy on the Mend

With the COVID-19 nearly in the rearview mirror, economic activity is well on its way to reaching pre-pandemic levels. The chart below illustrates where U.S. Gross Domestic product (GDP) currently stands:

The blue line represents Real GDP which is the value of all goods and services produced by the economy, adjusted for inflation.  The gray line is Real Potential GDP or the level of “potential” GDP as estimated by the Congressional Budget Office.  This measure assumes the nation’s capital and labor resources are put to effective use.   Historically, GDP has tracked potential GDP reasonably well.  The difference between these two measures is called the output gap.

When real GDP tracks below potential GDP, economic output is beneath its capacity and there is a negative output gap.  A negative output gap implies the economy is running below its potential and inflationary pressures are likely to remain muted.  Conversely, when real GDP tracks above potential GDP economic capacity there is a positive output gap.  A positive gap implies the economy is “running hot” and inflationary pressures build encouraging the Federal Reserve to increase short-term interest rates.

As illustrated in the chart above, real U.S. GDP experienced a historic decline, recovered somewhat quickly, but still remains below pre-pandemic levels and its potential.  The current negative output gap supports, at least in part, the Fed’s decision to keep short-term interest rates low through 2023.  While inflation has the potential to rise, the Fed does not want to raise short-term rates too early and endanger the nascent economic recovery.

Given the massive level of stimulus, the rollout of vaccines and pent up demand, the bond market questioned the Fed’s ability to keep short-term rates low over the next two years.  Since bond prices fall when interest rates rise, investors sold bonds in anticipation of future elevated economic growth, inflationary pressures and the potential for the Fed to increase short-term interest rates sooner than expected. This behavior drove up the yield on bellwether 10-year U.S. Treasury bond and helped explain the decline in the bond markets over the 1st quarter of 2021.

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