Since our last column in December, it seems that just about everyone has jumped on board with a very strong outlook for the economy this year. With ramped up vaccine distribution, a sharp reduction in new infections following the holiday surge and another huge U.S. stimulus package just passed, 2021 is likely to produce the strongest economic growth in decades. And for the first time in 15 years, global growth is likely to be led by the U.S. instead of China. China is further along in its recovery and is now pulling back on policy stimulus, while the U.S. is doubling down and is one of the world’s leaders in vaccine distribution.
Democrats gave up on trying to garner bipartisan support for a new U.S. fiscal package, and as a result, its size amounted to $1.9 trillion, at the high end of what had been expected. It’s worth taking stock of just how remarkable the last year has been in terms of the size of U.S fiscal spending. Including the $900 billion December bill and the CARES stimulus of last spring, the three packages together amount to a whopping $5 trillion, equivalent to some 20 to 25 percent of U.S. GDP. In addition to stimulus checks of $1,400 per person—the largest yet—the latest package contains extended unemployment benefits, expanded tax credits and hundreds of billions for state and local governments, schools, small businesses and vaccine distribution. This is generating another huge increase in income—as well as a boost to spending—that will show up in the March and April data.
To grasp the potential for an economic boom when things begin getting back to normal, it is important to bear in mind that not nearly all of this extra income coming from the government has been spent, so savings have also surged. The savings glut is also coming from high income and wealthy households, who have not been spending what they usually do on unavailable services such as travel, restaurants and entertainment.
The amount of excess savings provides some indication of the size of the pent-up demand that will be unleashed when these services become available again. Savings have risen about $3 trillion over the past year, compared with around $1 trillion the year before, suggesting something like $2 trillion in excess savings. The surge in income from the current package that will show up this month and next will add significantly to that savings excess.
With a growing consensus for a booming economy, the risk is now all on the downside. It is centered on more contagious COVID variants, as well as pandemic fatigue that is fostering less cautious behavior. The case for optimism is based on the premise that the combination of accelerated vaccine distribution, the number of people who have acquired immunity by having been infected, warmer weather and efforts to mitigate the spread through mask-wearing and social distancing will be more than enough to offset the spread of the new variants. But the risk should not be dismissed. The new variants are making up an increasing share of new infections in most countries around the world. And while the U.S. and UK have shown great progress in vaccine distribution, Japan and many European and emerging market countries have inoculated a much smaller share of their populations. Meanwhile, mobility indices—which measure the extent to which people are getting out and about—have been increasing worldwide over the past month, with the U.S. showing its highest levels since the pandemic began.
Financial markets, meanwhile, have been focused on the risks associated with rising inflation and bond yields. While we think a resurgence in the virus is worth worrying about, we view the rise in inflation and bond yields as largely constructive.
We do seem to be in the midst of an acceleration in inflation, and it’s likely to persist through most, or even all, of this year. That said, we don’t see it as a major concern at this point. First, it’s coming from an extremely low level. The core PCE deflator—the Fed’s preferred measure of underlying inflation—fell to just 1 percent after the pandemic hit. This followed a decade in which it ranged between 1.2 to 1.7 percent, persistently below the Fed’s 2 percent target. So, while bottlenecks in goods production and delivery are likely to elevate inflation to more than 2 percent in the next quarter or two, that should not be cause for alarm. Looking beyond the next six months or so, structural factors, such as international competition, automation and online shopping, are likely to be powerful moderating forces that will keep inflation from becoming a serious problem.
A sharp rise in bond yields has also caught the market’s attention. But it is actually a normalization from unusually low and unsustainable levels. The plunge in 10-year U.S. Treasury yields to 0.5 percent in the wake of the pandemic was not a sign of economic health. The rebound since then is due to both higher inflation expectations and real rates—reflections of the success of monetary and fiscal policy in cushioning the economy and financial markets, as well as optimism that containment of the virus will generate very strong economic growth. Yields in the 1.5 to 2 percent range are nowhere near enough to snuff out the economic recovery or the stock market. In fact, bonds had been showing more signs of a bubble than stocks; while the S&P has risen around 75 percent since its March 23 low, it is up a more reasonable 15 percent since its pre-pandemic peak more than a year ago. Ten-year U.S. Treasuries, meanwhile, had traded mostly in a range of 1.5 to 3 percent for a decade before COVID, and they are now back in that range and likely to remain there.
While the outlook for the economy and financial markets seems rosy for now, there are legitimate concerns about how this will all end. In addition to the historic amount of fiscal stimulus, central banks have unleashed a record amount of liquidity, even exceeding what we had seen during the financial crisis. To be sure, there are already signs of bubbly prices for various assets, including some individual stocks. But neither the economy nor asset prices seem about to tip over at this point with so much fiscal stimulus forthcoming and with a Fed that has made it clear that it will be unusually patient in removing accommodation. It is important to keep in mind, however, that the slower the Fed reacts to a booming economy and the surge in asset prices, the more it will have to do later to slow things down. In addition, the huge increase in federal debt and the rise in bond yields will exacerbate the need for fiscal tightening after the pandemic is contained. All of this reinforces our view that this will not end well. We believe payback—when it comes—is more likely to take the form of burst asset bubbles, along the lines of the last two recessions, as opposed to unacceptably high inflation that induces excessive Fed tightening, as occurred in the ‘70s and ‘80s.
