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The market reactions after Donald Trump’s election suggest that investors believe his policies will produce significantly faster economic growth. But can major new infrastructure spending, lower tax rates, and regulatory overhaul generate strong growth? Probably not at this stage of the economic cycle. While anticipated policy changes may provide some improvement, tightness in the labor markets will likely restrain any strong surge of growth.

For economic growth to accelerate, the economy must have the resources needed to satisfy new demand. When resources are in short supply, increased demand tends to drive prices higher rather than meaningfully increase growth. After seven years of economic recovery, with signs of rising inflation already starting to appear in some areas, a surge of policy-induced demand might do more harm than good.

Labor is an essential input for most economic activity, and so the supply of labor limits how fast the economy can grow over the longer term. Early in a new cycle, when unemployment is high, an economy can exceed the sustainable growth rate. Once the pool of surplus workers has been drawn down, however, strong new demand forces employers to bid wages up. Even then, they may not be able to attract and retain all the help they need.

Economists posit that two factors determine how fast the economy can grow without major inflationary pressure. The first is the rate at which the labor force grows. As more people go to work, the amount of goods and services produced increases.

As the huge group of baby boomers retires from the workforce, their departure is limiting the size of the labor force and the potential growth of the economy. In the late 1970s, as the Baby Boom generation entered the workforce, labor force growth added roughly 2.5% to the growth potential of the economy. Now, under the pressure of retiring baby boomers, the labor force growth is only 0.7%. Based solely on labor force expansion, the growth potential of the economy is almost 2% lower than it was when baby boomers entered the workforce.

The second way to support sustainable, noninflationary growth is through improving labor productivity. Even if the labor force does not grow, the economy can expand as long as the existing workforce increases the goods and services it produces.

Unfortunately, however, labor force productivity has declined. The retirement of the boomers could be one part of this. Experienced workers are often more productive than new workers, so a large number of retirements could reduce productivity. Since the generation that follows the baby boom (the “baby bust” generation) provides a much smaller number of workers, we may be facing a particularly acute shortage of experience as boomers leave the workforce.

Productivity improvement also often depends upon technological innovation and the willingness of employers to invest in those new technologies. Until the next major technological revolution becomes implemented, productivity improvement may remain low.

Over the last 60 years, productivity increases have added 2% to 3% to the overall growth potential of the economy. More recently, that number has fallen to 0.6%. That means the economy’s potential for expansion based on productivity improvements alone is 1.5% to 2.5% less today than it was in the past.

Economists add the labor force growth and productivity improvement together to determine the overall sustainable growth rate. That total suggests the economy can currently grow only about 1.2% without generating stronger inflationary pressure. Apparently, even the anemic 2.1% growth achieved since 2009 is more than we should expect from the economy on a sustainable basis. Even though the economy was able to grow 3% or 4% net of inflation over long periods of time in the past, this framework indicates the current economy probably cannot.

Bear in mind, too, that the labor shortages do not develop uniformly across all segments of the economy. Large numbers of unemployed manufacturing workers cannot help to alleviate a shortage of doctors or skilled machine tool operators. As with the economy in general, major shortages of labor in a few professional areas may limit the ability of the overall system to produce goods and services. For example, a major shortage of doctors would impose enormous limitations on the healthcare system’s ability to treat patients.

Some of the anticipated policy changes would be more constrained by labor availability than others. Regulatory reform, for example, probably depends less on the labor supply than the other anticipated policy changes and might even allow some companies to become more productive. Reduced regulation may not lift the economy dramatically, but it should help.

Lower tax rates could encourage some additional spending and investment. Yet tax reform promises both winners and losers so the net economic incentives to spend or invest may not change very much. Moreover, with unused capacity in many industries, “repatriated money” and other tax savings are more likely to go into share buybacks or acquisitions than into construction and other economic expansion.

Infrastructure projects and other federal spending seem most likely to conflict with emerging labor shortages. Construction managers have already reported difficulty finding enough skilled labor. A major infrastructure program might simply make that situation worse. Bear in mind, too, that signs of more rapid wage growth in some of the skilled areas might be all it takes for the Federal Reserve to begin forcefully slowing the economy with higher interest rates.

At this point, effective government spending probably needs to be much more limited and much more targeted than it could be earlier in a cycle. Will the administration’s changes add to growth? Most likely it will deliver some, although the political reality is that it will probably deliver less stimulus and require longer to take effect than many anticipate. Additional growth would also face headwinds from the natural slowing of an aging cycle and potentially be exacerbated by the adverse demographic trends. We hope that some of what the incoming administration can implement will help increase the rate of economic growth. Realistically, though, we must realize that we are at a point in the economic and demographic cycles where strong stimulus programs may generate less growth and more inflation.

About Bruce McCain

Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com. Bruce joined a predecessor of Key in 1987, after spending six years on the business faculty of the University of Iowa’s Henry B. Tippie College of Business. Bruce earned a PhD in Business Administration from the University of California at Berkeley, and undergraduate degrees in Psychology and Accounting from Boise State University.

Disclosures

This material is presented for informational purposes only and should not be construed as individual tax or financial advice.

KeyBank does not give legal advice.