However, over the long term what we believe is most important is potential, i.e. how fast the economy can grow. And that depends on two variables: growth in the workforce and the productivity of that workforce. Given this, should investors be worried about the recent drop in productivity? Probably.
Market Realist – Potential GDP and its components are the figures that you should be paying attention to.
Potential GDP is the highest level of GDP that’s sustainable over the long term. However, there can be times when the actual GDP is above the potential GDP. Potential GDP is also called “natural GDP.”
However, the economy tends to heat up at that point, leading to inflation. This means that the Fed has to increase rates in order to rein in inflation, which tends to cool the economy down.
Typically, the Fed—and most other central banks—tries to keep the actual GDP curve close to the potential GDP by controlling the interest rates in its economy. If the actual GDP strays below the potential GDP, the central bank will cut rates in order to revive growth.
Currently, the economy seems to be in a strong foothold. Inflation, however, remains low due to the dip in oil (USO) prices. The US equity markets (SPY)(IVV), which are the economy’s forward indicators, are buoyant. However, the stronger dollar (UUP) and lofty valuations are some of the headwinds facing US equities that have caused volatility (VXX) to spike lately.
The graph above compares the real GDP (nominal GDP minus inflation) with the potential GDP per the Congressional Budget Office up to July 2025. As you can see in the graph, we’re now heading into a flattish period of potential GDP. This is mainly due to the dip in labor productivity, which we’ll delve into in the next part of this series.