A potential explanation for a puzzling economy

A potential explanation for a puzzling economy


Derek Hamilton

  • Managing Director, Economist – Ivy Equity Boutique
  • Read bio

The US economy continues to grow well above its potential growth rate, which is the natural growth rate of gross domestic product (GDP) over time. At the same time, inflation has been moving lower while the unemployment rate has gradually risen. These observations seem inconsistent with one another.

What is causing this strange sequence of events?

Potential GDP is a measure of the total productive capacity of an economy, and its growth rate can be estimated by adding the growth rates for the labor force and productivity. Theoretically, when an economy’s rate of growth exceeds its potential rate of growth, excess capacity falls, inflation rises, and unemployment usually declines. US GDP grew by more than 3% in 2023 (fourth quarter over fourth quarter), while the trend growth rate for potential GDP is thought to be slightly below 2%, implying tighter capacity. This should have resulted in more inflation pressure and lower unemployment, but the opposite occurred.

We believe the answer to this puzzle can be found in an outsized rise in the labor force, which has been heavily influenced by immigration. The US demographic profile suggests the natural growth rate for the labor force should be around 0.2% per year, but the labor force rose by 1.5% in 2023. Breaking this down further, the growth rate for foreign-born workers posted the largest annual gain in the 15 years since this data started being collected.

The chart below shows that the number of foreign-born workers has risen above its long-term trend. From 2018 to 2021, the number of workers in this category saw little change due to crackdowns by former President Trump and the COVID-19 lockdown. Now, a combination of loosening backlogs for official immigration and a spike in illegal border crossings has boosted labor force growth. Higher labor force growth has allowed the US economy to grow at a more rapid pace without increasing inflation and reducing unemployment.

If labor force growth continues to surprise to the upside, the US economy could continue to grow faster than expected without generating inflation. Our guess is that labor force growth slows this year, but we will be watching closely.

Foreign-born workers in the US

>Foreign-born workers in the US

Note: Dotted line represents the trendline.

Sources: Macrobond, Bureau of Labor Statistics.

Chart is for illustrative purposes only.

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