# FiveThirtyEight

## Economics

In the way parents obsess about their kids’ “potential” — in sports, smarts or, dare I say, earnings — economists obsess about a similar question: Is the United States living up to its potential? This concept of “potential” sounds squishy, and yet economists research it intensely because it has huge implications for how the Federal Reserve responds to the sluggish U.S. recovery.

On Wednesday afternoon, when Janet Yellen concludes her first meeting as Fed chairwoman, many people will focus on questions like, is the Fed going to slow its bond purchase program? Or, when will the Fed begin to raise interest rates — in late 2015, or sooner? Undergirding these questions is the much larger issue of U.S. potential.

Traditional macroeconomic thinking suggests that if the U.S. economy is living up to its potential, the Fed should pull back the huge amounts of stimulus it has injected into the economy. On the other hand, if the economy is falling far short of its potential, there would be a strong argument for continuing, or accelerating, stimulus.

What does economic potential mean?

Questions about potential bedevil macroeconomists, because much like individual potential — What’s my ceiling as a musician? How good at basketball could he be? How far in business will she go? — an entire economy’s potential is impossible to measure.

Yet we measure it anyway. An economy’s potential growth rate is an estimate of how fast it can grow if it used all available resources. Think of resources in the broadest possible sense: the available labor force (those willing to work); all the available “capital” — machines, land, buildings, etc.; and all the technology and ideas that could boost productivity. Institutions like the Fed and the nonpartisan Congressional Budget Office combine these factors to produce estimates for the U.S. economy’s potential growth rate.

This rate can change, of course. In the U.S., it’s been slowing for a while. The chart below plots the CBO’s estimate of the year-over-year percent change in potential real GDP growth rate, projected through 2024.

As the chart shows, the rate has declined from about 4 percent in the 1950s to just under 2 percent today. Demographics are a key reason for this drop. As baby boomers retire, the labor force shrinks, thus lowering the economy’s potential growth. Slower increases in productivity and less investment in the country’s capital stock are also important factors.

An economy can grow faster than its potential, but if it does, trouble may ensue. An economy growing too fast might trigger a quick rise in prices, or inflation. Fed officials generally want to avoid an “overheating” scenario, such as the high inflation rates experienced in the U.S. during the 1970s and 1980s. Economic growth is like Goldilocks’ porridge: You want it “just right,” not too fast or too slow.

The chart below shows potential and actual real GDP levels, as estimated by the CBO and reported by the U.S. Bureau of Economic Analysis, respectively, going back to 2007.

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