Staff Analytical Note/Note analytique du personnel—2023-5

Last updated: May 9, 2023

Assessing global potential

output growth and the US
neutral rate: April 2023
by Salma Ahmed, Aviel Avshalumov, Tania Chaar, Eshini
Ekanayake, Helen Lao, Louis Poirier, Jenna Rolland-Mills, Argyn
Toktamyssov and Lin Xiang

International Economic Analysis Department

Bank of Canada
SalmaAhmed@bankofcanada.ca, aavshalumov@bankofcanada.ca,
tchaar@bankofcanada.ca, eekanayake@bankofcanada.ca,
hylao@bankofcanada.ca, lpoirier@bankofcanada.ca,
jrolland-mills@bankofcanada.ca, atoktamyssov@bankofcanada.ca,
lxiang@bankofcanada.ca

Bank of Canada staff analytical notes are short articles that focus on topical issues relevant to the current economic
and financial context, produced independently from the Bank’s Governing Council. This work may support or
challenge prevailing policy orthodoxy. Therefore, the views expressed in this note are solely those of the authors and
may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank.
DOI: https://doi.org/10.34989/san-2023-5 | ISSN 2369-9639 ©2023 Bank of Canada
Acknowledgements
We would like to thank Harriet Jackson, José Dorich, Subrata Sarker, Justin-Damien Guénette,
Fotios Raptis and Konrad Zmitrowicz for their useful comments and suggestions. We also
thank Ce Shang for excellent research assistance. In addition, we thank Jordan Press for
excellent editorial assistance and Eric Bannem for help translating parts of this note into
French.

i
Summary
We present the annual update of Bank of Canada staff estimates for global potential output
growth and the US neutral rate of interest. Both estimates serve as key inputs to the analysis
in the April 2023 Monetary Policy Report.

Global potential output growth

We expect growth in global potential output to increase from 2.5% in 2022 to 2.8% by 2026
(Chart 1). This increase is due mainly to a pickup in the growth of trend labour productivity
(TLP) as firms adopt more efficient organizational and management practices and implement
new and previously developed technologies. In addition, TLP growth is expected to return to
more normal levels in the euro area and rest-of-world region (RoW) after having been
disrupted by Russia’s invasion of Ukraine.
Chart 1: Global potential output grow th expected to pick up after
2022
Percent change, percentage points contributions, annual data %
6

0
2003 2008 2013 2018 2023

Trend labour input Trend labour productivity

Potential output growth Potential output growth (April 2022)
Source: Bank of Canada calculations Last data plotted: 2026

In contrast, the growth rate of trend labour input (TLI) is projected to fall modestly between
2022 and 2026. Population aging is expected to reduce growth in the global workforce,
particularly in China. TLI growth rises moderately in only two regions over this period: the
United States and emerging-market economies (EMEs). This growth is due, respectively, to an
expected pickup in net immigration and to a population that is young and growing.

Overall, our estimates of growth in global potential output have been revised down slightly
compared with the April 2022 assessment. Larger effects of the war on the economies of the
euro area and RoW and less robust growth in trend total factor productivity (TFP) in China
account for the change. By contrast, stronger-than-expected net immigration led to an
upward revision to potential output growth in the United States.

1
US neutral rate
The US neutral rate is our proxy for the global conditions that affect the Canadian neutral
rate. Our conclusion is that the April 2022 assessment—which estimated a range for the US
neutral rate of interest between 2% and 3%—remains appropriate.

We organize the remainder of this note as follows. First, we provide a detailed regional
breakdown of estimates for potential output (Table 1). Then we shed some light on the risks
to these estimates. Finally, we elaborate on Bank staff’s assessment of the US neutral rate.

Table 1: Projection for potential output growth

Share of real Projected growth† (%)

global gross
domestic
2021 2022 2023 2024 2025 2026
product* (%)
1.2 1.7 1.8
United States 16 1.8 1.8 1.7
(1.3) (1.6) (1.7)
0.8 1.2
Euro area‡ 12 1.2 1.3 1.1 1.1
(1.4) (1.1)
0.6 0.6 0.7
Japan 4 0.6 0.8 0.7
(0.7) (0.8) (0.8)
5.2 4.8 4.7 4.5
China 19 4.3 4.2
(5.5) (5.2) (5.1) (4.9)
3.0 3.3 3.5
Oil-importing EMEs§ 33 3.7 3.7 3.9
(3.1) (3.4) (3.7)
1.6 0.7 1.3 1.7
Rest of the world◊ 17 1.7 1.8
(1.7) (1.9) (1.8) (1.8)
2.6 2.5 2.7 2.8
World 100 2.8 2.8
(2.7) (2.9) (2.9) (2.9)
* Gross domestic product (GDP) shares are based on International Monetary Fund (IMF) estimates of the purchasing-
power-parity valuation of country GDPs for 2021 from the IMF’s October 2022 World Economic Outlook. The individual
shares may not add up to 100 due to rounding.
† Numbers in parentheses are projections used in the April 2022 Monetary Policy Report and are reported only when
different from the current projection.
‡ Croatia joined the euro area on January 1, 2023. The current projection and historical data do not include the change
in membership.
§ The oil-importing emerging-market economies (EMEs) group excludes China. It is composed of large EMEs from Asia,
Latin America, the Middle East, Europe and Africa (such as India, Brazil and South Africa) as well as newly industrialized
economies (such as South Korea).
◊ “Rest of the world” is a grouping of other economies not included in the first five regions. It is composed of oil-
exporting EMEs (such as Russia, Nigeria and Saudi Arabia) and other advanced economies (such as Canada, the United
Kingdom and Australia).

2
Regional estimates for potential output growth
United States
In 2020 and 2021, US potential Chart 2: US potential output grow th to return to pre-pandemic rate
Percent change, percentage points contributions, annual data
output growth slowed as %
3
population aging and the
COVID-19 crisis negatively 2
affected TLI growth (Chen et
al. 2020). These negative 1

effects were partly offset by

increases in TLP growth— 0

linked mainly to investment in

-1
information and 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025
Trend total factor productivity
communications technology Trend labour input
Capital deepening
driven by the pandemic Potential output growth
Potential ouput growth (April 2022)
(Boutilier et al. 2022). As the Source: Bank of Canada calculations Last data plotted: 2026

economy recovered in 2022, TLI growth rose and TLP growth returned to a level close to that
estimated in 2019. These developments pushed potential output growth closer to its pre-
pandemic average (2015 to 2019) of 1.7%.

Potential output is expected to continue to grow at a rate close to its pre-pandemic average
between 2023 and 2026 (Chart 2). TFP is expected to be the largest source of growth over the
projection. The end of the disruptive effects of the pandemic drives TFP growth, as does
firms’ adoption of digital technologies and other new ways of operating. TLI is also expected
to contribute positively to potential output growth, on average, over this period, as net
immigration continues to rebound from the effects of the pandemic (Box 1). This is partly
offset by a modest decrease in the trend labour force participation rate due to the aging of
the US workforce.

Relative to the April 2022 assessment, potential output growth is revised down by 0.1
percentage point (pp) in 2021 and up by 0.1 pp in 2022 and 2023. The downward revision in
2021 is due mainly to a rise in excess retirements that led to a lower trend participation rate
than previously expected. The upward revisions in 2022 and 2023 reflect slightly higher
population growth. This is partly offset by lower trend labour force participation due to a
higher retirement rate among older workers. 1 As a result, the level of potential output is 0.1%
higher by 2024 compared with the April 2022 assessment.

1
The stronger profile for net immigration is from the most recent demographic outlook published by the
Congressional Budget Office. The downward revision of the trend labour force participation rate mainly reflects
the assumption that retirement rates among the population age 55 and over remain elevated over 2023–26.

3
Box 1: The role of immigration in explaining US potential output
Immigration influences potential output in the United States by: Chart 1-A: Com parison of labour force
participation rates %
• raising population growth 67
66
• increasing the participation rate, since foreign-born 65
64
individuals tend to have higher participation rates than
63
workers born in the United States (Chart 1-A) 62
61
• reducing the natural rate of unemployment by 60
US-born Foreign-born
improving matching efficiency in the labour market 2017 2022
Source: Bureau of Labor Statistics via Haver Analytics
(Orrenius, Zavodny and Gullo 2020)

• increasing trend labour productivity by contributing to Chart 1-B: Net im m igration rebounded in 2022
Annual data Thousands of people
innovation 2 2,000

1,500
In this box, we present estimates of the impact of immigration
1,000
on potential output growth from the first two of these channels
500
for the period 2022–26.
0
Net immigration in the United States averaged around 1 million -500
people per year from 2010 to 2019. The COVID-19 pandemic 2010 2012 2014 2016 2018 2020 2022 2024 2026
Foreign-born people without legal status
led to sharp declines in immigration in 2020 and 2021 (to about Legal temporary residents
Lawful permanent residents
400,000 people annually, on average) due to border closures Total
and challenges in processing visas. In 2022, the Congressional Source: Congressional Budget Office Last data plotted: 2026

Budget Office estimated that net immigration rebounded to close to 1.3 million, largely because of an
increase in foreign-born people without legal status (Chart 1-B). If net immigration had been zero in
2022, population growth, the participation rate and potential output growth would be 0.5 pps, 0.3 pps
and 0.7 pps lower in 2022, respectively.

Between 2023 and 2026, strong net immigration is expected to support population growth and the
participation rate, offsetting downward pressures from population aging and a declining birth rate. In
our base-case projection, population growth averages 0.8% annually and the average participation
rate is 61.6% from 2023 to 2026. To highlight the importance of immigration in our base case, we
present an alternative scenario in Table 1-A where net immigration is zero over 2023–26. In this
scenario, population growth averages about 0.4% annually—roughly half the average growth rate in
the base case. Moreover, the trend participation rate is about 0.1 pp lower, on average. As a result,
average potential output growth is 1.3% in the alternative scenario—0.5 pps lower than in the base
case.

Table 1-A: Components influenced by immigration (base case versus alternative scenario)

Population growth Participation rate Potential output growth

Alternative Alternative Alternative
Base case Base case Base case
scenario scenario scenario
2023–2026 0.8% 0.4% 61.6% 61.5% 1.8% 1.3%

2
According to Bernstein et al. (2022), immigrants are important contributors to US innovation. They represent 16%
of all US inventors but produced nearly 25% of total innovation output from 1990 to 2016.

4
Euro area
After a brief bounce-back Chart 3: High energy prices weighed on euro area
to near pre-pandemic potential output %
Percent change, percentage points contributions, annual data
rates in 2021, potential 2.0
output growth in the 1.5
euro area is estimated to
1.0
have slowed sharply in
0.5
2022 because of Russia’s
invasion of Ukraine 0.0

(Chart 3). The surge in -0.5

2003 2008 2013 2018 2023
domestic energy prices
Trend labour input Trend total factor productvity
was a significant supply Capital deepening Potential output growth
shock to the euro area Potential output growth (April 2022)

economy (Box 2). In Source: Bank of Canada calculations Last data plotted: 2026
2023, potential output
growth should recover as the drag from high energy prices on trend TFP growth abates.

Over 2024–26, potential output growth is estimated to grow around 1.1%. Capital deepening
is expected to accelerate as private investment strengthens and public investment increases.
The latter is due to the continued implementation of recovery and resilience plans—a key
part of NextGenerationEU funding. 3 In contrast, TLI growth is expected to slow due to
population aging.

Compared with the April 2022 assessment, our estimate of potential output growth is 0.5 pps
lower in 2022. The negative impact of high energy prices on trend TFP growth—which
disproportionately affected activity in highly productive industrial sectors—largely explains
the revision. The level of potential output is 0.4% lower by 2024, as trend energy prices
remain above their pre-invasion levels.

3
NextGenerationEU is an €800 billion fiscal package launched in 2021 to support the recovery of European Union
member states from the COVID-19 pandemic (European Commission 2021).

5
Box 2: The impact of higher energy prices on potential output in the
euro area
Energy prices rose sharply in the euro area in 2022—particularly for natural gas—because of Russia’s
invasion of Ukraine and related sanctions targeting the Russian economy. Energy is an important
input to the production process in the euro area. A sustained hike in energy prices due to the reduced
availability of natural gas supplies lowers potential output in the euro area. This box presents a
methodology to estimate the impact of higher energy prices on the euro area’s potential output.

We assess the implications of high and sustained energy prices for potential output by expanding a
standard Cobb–Douglas production function to include oil (O) and natural gas (G) as inputs into the
production process. 4 Equation (1) shows the modified production function:

𝑌𝑌 𝑝𝑝𝑜𝑜𝑡𝑡 = 𝐴𝐴𝐾𝐾 𝛼𝛼 𝐿𝐿1−𝛼𝛼−𝜇𝜇−𝜏𝜏 𝑂𝑂 𝜇𝜇 𝐺𝐺𝜏𝜏 , 𝑤𝑤ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝛼𝛼 = 0.31, 𝜇𝜇 = 0.025 𝑎𝑎𝑎𝑎𝑎𝑎 𝜏𝜏 = 0.019. (1)

All else equal, decreases in the availability of oil and

natural gas will lower potential output in the euro Chart 2- A: Change to potential
output grow th in the euro area from
area. 5 The decrease of each input (O and G) can be high energy prices
estimated by multiplying its price elasticity of demand Pecentage points contributions, annual data pps

by the expected change in its price due to Russia’s 0.1

invasion of Ukraine. Empirical estimates suggest a price 0.0

-0.1
elasticity of oil and natural gas demand of -0.13 and -
-0.2
0.15, respectively. 6 Moreover, the projected trends of
-0.3
oil and natural gas prices, measured against pre-
-0.4
invasion counterfactuals, yield higher oil and natural
-0.5
gas prices (8% and 220%, respectively, over 2022–25). 7
-0.6
This means that the amount of oil and gas used in 2022 2023 2024 2025
production should be about 1% and 33% lower over
Gas Oil Total
2022–25, respectively. Finally, we use the factor shares 𝜇𝜇 Source: Bank of Canada calculations Last data plotted: 2025
and 𝜏𝜏 to calculate the impact on potential output of the
decline in each factor. On average, these factor shares and the estimated declines of oil and natural
gas imply that potential output is about 0.15% lower over 2022–25. The same calculations can be
done for each year. We estimate that higher trend energy prices reduce potential output growth by
about 0.5 pps in 2022 (Chart 2-A) and total a 0.6% reduction in the level of potential output by 2024.

4
Some studies propose other methods of modelling energy as a productive input—including constant elasticity of
substitution (CES) and a nested CES function for the substitution of capital, labour and energy inputs—that allow
for technological change. See Dissou, Karnizova and Sun (2015), Klump, McAdam and Willman (2012) and
Schubert and Turnovsky (2011). An exercise using an alternative nested CES production function, however,
suggests the results are not very sensitive to the structure of the production function.
5
Assuming perfect competition, flexible wages and a limited impact on the capital stock, the effect on output from a
shift in the relative price of energy can be approximated by the factor share of energy multiplied by its price
elasticity of demand (Hamilton 2012).
6
Estimates of the short-run demand elasticity of crude oil range from -0.9 to -0.03, with the median of -0.13.
Meanwhile, empirical studies find short-term demand elasticity of natural gas in Europe ranges from -0.24 and
0.02. See Caldara, Cavallo and Iacoviello (2019), Di Bella et al. (2022) and Erias and Iglesias (2022).
7
We convert both oil and natural gas prices into euros and adjust them using the projected GDP deflator for the
euro area.

6
China
China’s potential Chart 4: China's potential output grow th to slow further
Percent change, percentage points contributions, annual data
output growth is %

expected to fall
12
10
gradually over the
8
projection horizon, as 6
the growth of both TLI 4
and TLP decline 2

(Chart 4). 0
-2
TLI growth is expected 2003 2008 2013 2018 2023

to fall from -0.3% in Trend labour input Capital deepening

2022 to -0.7% in 2026. Trend total factor productivity Potential output growth
Potential output growth (April 2022)
The fall mainly reflects
Source: Bank of Canada calculations Last data plotted: 2026
the decline in the size
of the workforce due to population aging. In addition, TLP growth falls over 2023–26, as
declining contributions to growth from capital deepening are only partly offset by rising
contributions from trend TFP. Spillovers from the correction in the property market drive the
expected evolution of capital deepening. Trend TFP growth increases in 2023 due to the
lifting of the government’s “zero-COVID” strategy. Going forward, the intensification of
decoupling from the United States and other advanced economies on the trade and
technology fronts is expected to constrain inflows of foreign direct investment (FDI) and
weigh on trend TFP growth.

Compared with the April 2022 assessment, our estimate of potential output growth is revised
down over history and is 0.4 pps weaker, on average, over 2022–24. Overall, the level of
potential output is 2.3% lower by 2024. Downward revisions over 2022–24 mostly reflect a
reduction in trend TFP growth linked to policy uncertainty that has intensified over the past
year. In addition, FDI flows in 2022 came in weaker than previously forecasted. We expect that
weakness to persist over the projection due to Western-imposed restrictions on imports of
advanced technology, which slow the pace of technological adoption in China. Updated UN
population projections led to a small upward revision to China’s TLI growth. However, this is
offset by a downward revision to our estimate of the contribution of capital deepening to
potential output. 8, 9

8
Our assessment of TLI is expected to evolve in line with the latest UN medium fertility scenario for population
growth assuming that the average retirement age of 60 remains constant over the projection.
9
We have reduced our assumption of the capital income share (α) from 50% to 40%, in line with the recent literature
(Marie, Cristina and Cyril 2015; IMF 2023).

7
Oil-importing emerging-market economies
Potential output growth in
Chart 5: Potential output growth of emerging-market
oil-importing EMEs is economies to recover slowly
Percent change, percentage points contributions, annual data %
estimated to recover
6
steadily between 2022 and 5
2026. This is mainly because 4
of a recovery in capital 3

deepening and TLI growth 2

as scarring effects from early 1

in the COVID-19 pandemic 2003 2008 2013 2018 2023

0

dissipate (Chart 5).

Capital deepening Trend total factor productivity
Additionally, trend TFP
Trend labour input Potential output growth
growth is projected to
Potential output growth (April 2022)
improve modestly due to
Source: Bank of Canada calculations Last data plotted: 2026
firms in this region gradually
catching up to the technological frontier.

Compared with the April 2022 assessment, potential output growth is revised down on
average by 0.1 pp over 2022–24. The limited changes to potential output growth are the
result of competing factors. We expect the weakness in capital deepening observed in 2022
to persist through 2024 as EMEs face slower growth, tighter financial conditions and higher
levels of debt than previously forecasted. Weaker capital deepening is also expected to
constrain TFP growth over the same horizon (World Bank 2023). These negative effects are
largely offset by stronger-than-projected trend labour force participation, which has shown
less evidence of scarring from the pandemic than previously anticipated.

8
Other regions
Potential output growth in Japan is expected to remain tepid, averaging 0.7% over 2023–26,
as a rapidly aging population continues to weigh heavily on TLI growth. The main driver of
potential growth continues to be TFP, reflecting advances in digitalization. Potential output
growth is little changed compared with the April 2022 assessment.

Potential output growth in the RoW region is expected to recover gradually but to remain
below its pre-pandemic average of 2% over 2017–19. RoW potential output growth is
expected to have slowed to 0.7% in 2022. This is due to the heavy impact of international
sanctions on potential output in Russia after its invasion of Ukraine. Russia’s drag on RoW
potential output growth is expected to decline gradually over the projection horizon.
Compared with the April 2022 assessment, our estimate of potential output growth has been
revised down by 0.6 pps, on average, over 2022–24, based on our updated assessment of the
impact of the war on the region. As a result, the level of potential output in 2024 is 3.1%
weaker than in the April 2022 assessment.

9
Uncertainties around the outlook for global potential
output growth
Our assessment is subject to several uncertainties.

On the downside, the future shape of global supply chains has become less certain following
the trade war between China and the United States, the COVID-19 pandemic and Russia’s
invasion of Ukraine. Climate change could also help reconfigure supply chains as more
frequent extreme weather events could cause substantial disruptions to international trade. 10
In response to these events, firms are adjusting their supply chain practices and governments
are considering policies to relocate strategic industries closer to home. In the long term, near-
shoring or re-shoring could lower TFP growth by substantially increasing consumer prices,
lowering business profits, and reducing hiring and capital spending. 11

The upside risks to potential output remain the same as in our last assessment. Increased
investments in new digital technologies and remote work—both prominent outcomes of the
pandemic—could increase labour productivity. For example, firms could find it easier to hire
workers that otherwise may not have wanted to relocate for jobs. Renewable energy
investment could also be stronger than expected given recent public incentives, particularly in
Europe and the United States. Geopolitical considerations could also drive new energy
investments, particularly in Europe following Russia’s invasion of Ukraine.

10
For more, see Dunbar, Steingress and Tomlin (2023).
11
For instance, when asked by a journalist about the difference in production costs between the two jurisdictions, an
executive with the Taiwan Semiconductor Manufacturing Company Limited noted that construction costs in
Arizona can be four to five times greater than in Taiwan (see Xu 2023).

10
US neutral rate
Our assessment suggests that the US nominal neutral rate—our proxy for the global neutral
rate—lies within a range of 2% to 3%. This is unchanged from the April 2022 assessment
(Boutilier et al. 2022). As in 2022, our assessment is informed by a suite of structural models
capturing different drivers of the neutral rate. The neutral rate of interest is unobservable and
inferred from the evolution of the factors that influence it. Therefore, our estimate is subject
to considerable uncertainty.

This latest assessment accounts for two factors affecting the US neutral rate:

• mild upward pressure from an updated profile for US potential output growth

• a downward revision to the Congressional Budget Office’s projected profile for the
US government’s debt-to-GDP ratio between 2023 and 2026 12

Given that these changes are largely offsetting and that other factors influencing the US
neutral rate are roughly unchanged, our estimate of the US neutral rate is the same as in the
April 2022 assessment. 13

12
All else being equal, a lower ratio of government debt to GDP reduces the supply of safe assets and puts
downward pressure on the neutral rate.
13
Other factors include inequality and the demand for safe assets.

11
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