In a normal business cycle recovery, the economy gradually returns to full employment, causing a lagged return of inflation pressure. This gives monetary and fiscal authorities’ time to recalibrate policy before there is serious overheating. This cycle looks far from normal:
Super easy monetary and fiscal policy suggests the fastest business cycle recovery since the 1950s.
The recovery could be so hot, it starts to bump up against supply constraints before reaching full employment.
By late next year, policy-makers could face some very tough choices as they try to decide whether to pull back or not.
Two accelerators and no brakes? Never in history has the US had such a big, coordinated double dose of super-easy monetary and fiscal policy. Despite the drop in the unemployment rate from a peak of 14.3% to 6.3% the Fed shows no sign of withdrawing stimulus. Not to be outdone, the Biden Administration is proposing: a repeat of the 13% of GDP stimulus from last spring and an even bigger infrastructure plan to follow. Add to that another 14% of GDP in excess bank deposits from last year’s stimulus and the economy is primed for surging spending as it reopens. Michelle Meyer and team are forecasting 6.5% GDP growth this year and 5% next year compared to trend growth of less than 2%.
While inflation has been very sticky in recent years, we can’t rule out an early rise. A simple supply and demand framework illustrates the challenge (Exhibit of the day). The“aggregate demand curve” slopes down to the right—the lower prices are the more people will want to spend. Fiscal and monetary stimulus tend to shift the aggregate demand curve to the right. Meanwhile the“aggregate supply curve” slopes up—higher prices encourage firms to supply more goods and services. Moreover, it is common to assume that the supply curve gets increasingly steep as spare capacity shrinks and the economy approaches potential output and full employment.
The concern is that the US could hit the upward sloping part of the AS curve very quickly. If demand surges and businesses bring back capacity slowly there could be pockets of inflation. These short-run supply-side constraints are particularly relevant if a number of small businesses have closed for good. Many economists point to a temporary spike in year-over-year inflation in March and April as prices surge relative to depressed prices last spring. However, there could be a second surge due to a supply constrained reopening in late spring-early summer.
Looking further ahead, given the speed of the recovery, it could prove hard for policymakers to hit the brakes in a timely manner. The Fed is seeking an undefined overshoot of the inflation target and hence will wait until the last minute to hit the brakes. Meanwhile there is strong momentum towards additional fiscal stimulus, including a big infrastructure plan. With unified government, infrastructure spending should be relatively easy to pass since projects can be directed to reluctant Senators.
Our hope and expectation is that after years of low and sticky inflation, the increase will come slowly, buying time for a policy turn. But, we worry about a boom this year and next followed by a bust in 2023, as policy makers hit the brakes later, but harder. After all, once inflation starts to trend higher, it can only be stopped with at least some rise inthe unemployment rate. One of the rather depressing historical regularities is that the unemployment rate has never risen by more than 0.5% without a recession following. For now, however, let’s enjoy the ride.
My view is that US inflation will remain stronger than elsewhere but not overheated because China is hitting the brakes, commodities will tumble, dragging down CNY and EUR, driving up the USD.