The GDP Gap

Executive Summary

• The economy has not closed the GDP gap relative to the pre-COVID trend in nominal or real per capita terms.

•  Fiscal and monetary stimulus are proving to have massively diminished returns.

• The economy will be left with a persistent gap in real per capita terms.

• The standard of living continues to erode, and investors will tolerate even deeper negative real interest rates.

The GDP Gap

Over a year has passed since the bottom in economic data surrounding the lockdowns in March and April of 2020, and the economy rebounded strongly.   

By most measures, economic growth has exceeded the level of Q4 2019, the last quarter before the COVID impact. Long-term income or long-term growth is an important concept in economics because big purchases or investments into the economy are made with a projection of future income. 

Buying a home, for example, with a long-term mortgage uses an assumption of long-term future income. 

The long-term trend in per capita economic growth was very weak in the decade after the Great Financial Crisis.

Still, the standard of living or per capita GDP was increasing at a trend rate of 3.4%. 

Today, GDP in nominal terms is $68,605 per capita. The standard of living in nominal terms is $643 lower than the long-term economic trend. This gap between long-term projected per capita growth and actual growth represents a decline in the overall standard of living and a disinflationary force.

Economic projects that were started several years ago with assumptions of long-term growth will fall short on average if there is a persistent gap between current GDP per capita and the long-term trend. 

Nominal GDP Per Capita:Source: BEA, YCharts, EPB Macro Research

There is a $643 gap to make up in the coming quarters in nominal terms, something that is possible but will be difficult to maintain. 

In real terms, the gap is more alarming and represents clear long-term damage to the economy. 

Real per capita GDP is $58,447 in Q2 2021. 

From 2009 through 2019, real per capita GDP increased at a trend rate of 1.6%. That trend implies real economic growth per capita would have been $1,308 higher. 

Real GDP Per Capita:Source: BEA, YCharts, EPB Macro Research

Real GDP per capita is the best economic measure for the standard of living. The economy still has a major gap relative to the pre-COVID trend, which was a very weak trend compared to most of history. 

A persistent real GDP gap is a disinflationary force that will make it impossible for the Federal Reserve to tighten monetary policy sustainably. 

As real economic growth falls, investors are forced to accept lower real risk-free yields. 

The Federal Government was able to support real disposable personal income per capita through the pandemic. 

Real personal income increased, which is historically uncommon during a recession as job losses accelerate. 

With stimulus payments fading and real wage growth falling, real disposable personal income per capita has fallen back to the long-term trend line. 

Real DPI Per Capita:Source: BEA, YCharts, EPB Macro Research

Adjusted real income growth, which is total income minus government transfer payments and taxes, adjusted for inflation. 

Adjusted real income is only growing at 1.1% in June.

"Adjusted" Real Income Growth:Source: BEA, YCharts, EPB Macro Research

Real GDP per capita is materially below the long-term trend, and income, previously kept above trend by fiscal stimulus, is now at risk of falling below trend. The economy would then face an income hangover.

The gap between long-term GDP per capita and current GDP per capita is a disinflationary gap that even fiscal stimulus has not been able to fill. 

The Treasury bond market is responding to this persistent gap, recognizing that the economy cannot handle any monetary tightening with a major GDP gap. 

As real GDP per capita growth continues to fall over time, investors will be forced to tolerate deeper negative interest rates. If the nominal GDP gap persists, investors will be forced to tolerate lower nominal risk-free rates. The correlation between the direction of growth and the direction of interest rates will remain positive.