As we've mentioned frequently, budget projections and economic forecasts are inextricably linked in determining both the nominal dollar budget numbers and their size compared to GDP. Naturally, the ten-year projections that budget agencies like the Congressional Budget Office and Office of Management and Budget make are very uncertain, so deviations from those forecasts can have profound effects on the budget. A recent CBO report helpfully provides some background on how they make their economic projections and in particular, why they assume that the economy will never actually reach potential GDP.
For background, potential GDP is the amount of output the economy would produce if it was at full capacity but not at a level which would risk accelerating inflation. Thus, it does not represent literally the maximum possible output at the time but rather a trend line around which actual GDP moves during the business cycle. Thus, the growth rate of potential GDP and its relationship to actual GDP are very important in longer-term budget projections.
Of course, actual GDP is currently below potential by more than 2 percent, and it has been below it since mid-2006 and for 12 of the past 13 years. Here's how CBO describes its incorporation of cyclical effects:
For roughly the first half of its 10 year projection period (which currently runs through 2025), CBO projects the growth of actual output by estimating both the potential and the cyclical components of economic activity. For the latter part of the projection period, however, CBO does not estimate cyclical components.
In other words, CBO attempts to project economic growth in the first five years of its budget window but relies on a simplifying assumption that the economy is in “steady-state” in the second five years, rather than trying to predict booms or busts. In the past, CBO assumed that actual GDP would be exactly equal to potential GDP in this steady state. However, recently CBO adjusted that assumption.
Starting in last year's February baseline, CBO assumed that the economy would only reach 0.5 percent below potential and grow at the same rate as potential GDP thereafter. As before, CBO does not attempt to project the business cycle in the second five years, instead assuming an average of likely outcomes.