In any event, the Fed believes that potential growth was at roughly 2.3% when immigration was still very high, and that it is currently falling back to about 1.8%. We believe this figure to be 2% for now. However, assuming the economy will grow around potential, the additional tax revenue a 2% steady growth will generate won’t be sufficient to cover additional spending on defence, climate change control, additional care for the elderly and far higher interest payments.
In short, the medium-term outlook will be one of fairly low growth with rising public deficits. An additional problem here is the global upward inflationary pressure due to deglobalisation and protectionism. Another factor is labour market tightness caused by the ageing population. For now, we assume that (looming) labour shortages will not be adequately offset by AI induced productivity gains.
If this conclusion is correct, the Fed should ensure that growth ends up below the 2% potential growth rate rather than above it. In light of the tight US labour market, this will in our view mean the Fed will cut rates less than the market is currently discounting. Combined with stubbornly large public deficits and the worrisome long-term outlook for US government finances, this also means that interest rates will remain relatively high, and they could even rise. This, in turn, would be disastrous for public finances in the longer term. Ultimately, this will result in much higher taxes, which will severely dent economic growth, or increasing pressure on the central bank to pursue an inflationary policy. As the latter option is the road of least resistance, we expect that inflation expectations will rise much further in the coming years, as will long-term rates and borrowing costs.
Alarming European prospects
For Europe, the outlook is not better compared to the US:
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In Europe, workforce growth and productivity growth rates are far lower than in the US. Hence, potential growth in Europe is close to 1%.
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The Draghi report, published in September, clearly indicates that regulation in Europe is out of control and that there are far too few large European companies that can sufficiently invest in the development of new technology. This is partly because a real union in terms of banking and sales territory is still a long way away.
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Europe lags behind China and the US in terms of technological development. Furthermore, Europe’s supply lines of rare commodities are far less secure and the continent is still politically and militarily incapable of defending itself properly. Efforts are being made to this end, but it will take many years before Europe has its house in order.
All this means that growth in Europe cannot far exceed 1% in the coming years if the ECB is to keep inflation under control (lower interest rates and increases in real disposable income will likely boost growth somewhat in the period ahead). Europe is also grappling with persistent large public deficits and high government debt levels. In a low growth environment, it will be increasingly difficult to bring government finances on a sustainable path, given the large unfunded pension obligations and rising health care costs as a result of aging societies. Consequently, pressure on the ECB will increase as well to pursue an inflationary monetary policy in order to keep the governments funded at affordable levels.
Conclusion
In light of the above, we expect central banks in the US and Europe will be quick to lower rates if economic growth slows further, but will be slow to react in case the economy performs better than expected and inflation (expectations) are under upward pressure. This will result in more upward pressure on long-term rates, while short-term rates will likely remain low or will drop further in the coming quarters to years.
