Paul O’Connor, Head of the UK-based Multi‑Asset Team, responds to the planned $1.9 trillion fiscal stimulus from US President Biden’s new government, considering the implications for the US economy, monetary policy and the markets.
- Despite the unprecedented combination of super-charged US fiscal policy and a highly accommodative Federal Reserve, the balance of evidence still suggests that it is too early to worry about the risk of the US economy overheating.
- The impact of the fiscal splurge on the size of US government debt is a longer-term worry. While funding it is currently not difficult, the fiscal arithmetic could become more challenging if inflation picks up and interest rates and bond yields move meaningfully higher.
- The prospect of rapid US recovery combined with a gradual pickup in inflation is a very positive backdrop for financial markets. However, it is important to be alert to any threats to this rosy outlook, particularly the uncertainty surrounding economic forecasts.
In his speech to the Economic Club of New York on 10 February, US Federal Reserve (Fed) Chair Jay Powell reiterated his recent message that the US central bank was in no rush to rethink either its stance on interest rates or its asset purchase programme. Powell basically restated the broad guidance that was introduced in the Fed’s new monetary policy framework last year. This strategy shifted the Fed’s policy priorities to putting more emphasis on getting the US economy back to full employment and less on tightening monetary policy to pre-empt rising inflation. This is a patient and dovish Fed, that does not plan to raise rates until full employment has been reached and which does not expect to reduce asset purchases until “substantial further progress” has been made towards this goal.
Huge fiscal thrust
Of course, a lot has changed since the Fed introduced its new policy framework last summer. While back then, there was no clear path out of the pandemic and confidence in the global economy was low, consensus opinion on both fronts has significantly improved in recent months. The rapid development and rollout of vaccines has reinforced confidence in the ‘V’-shaped US recovery that is expected to surge through this year and into 2022. While a key question in financial markets last year was whether central banks could do enough to support the recovery, some are now beginning to wonder whether the Fed is doing too much, given the anticipated mid-year reopening and the scale of the fiscal stimulus now coming through from the new US administration.
The Biden government has moved boldly on the fiscal front, following up the previous administration’s US$900 billion December stimulus package with an additional US$1.9 trillion proposal that is now working its way through the legislative approval process. Scaled relative to gross domestic product (GDP), these packages are worth over 4% and around 9% respectively. While most commentators expect the current proposal to be scaled back a bit in the weeks ahead, it is nevertheless still expected to remain a massive fiscal injection. Beyond this lies an even bigger economic recovery plan that should emerge in the months ahead, focused on infrastructure, affordable housing and the environment. That is expected to be a US$2-3 trillion package, spread over four or five years.
Too much stimulus?
Economists are still scrambling to calculate the impact of these fiscal innovations from the new government. Unsurprisingly, consensus US GDP and inflation forecasts are rising and expectations for the size of the 2021/2022 boom keep climbing higher. Some commentators have expressed concern that the scale of the unfolding stimulus is excessive, since US households have already accumulated sizeable savings and are generally expected to get spending, once the service sector reopens in the months ahead. The impact of the fiscal splurge on the size of US government debt is a longer-term worry here, given that the stock of debt looks set to grow from a pre-pandemic 80% of GDP to well over 100% of GDP this year. While funding this is not difficult when interest rates are low and stable, the fiscal arithmetic could become more challenging later on if inflation gets sustainably back on target and interest rates and bond yields move meaningfully higher.
Global inflation remains subdued
For now, with the mutating coronavirus still a formidable adversary, US inflation well below target and US employment some 10 million jobs below pre-pandemic levels, the risk of fiscal policy overheating the US economy does not seem the most urgent concern. While consensus projections for US inflation have crept higher in recent months, even the most optimistic forecasters do not see the Fed sustainably reaching its objective here until around 2023. Furthermore, neither fiscal dynamics nor broader growth momentum are as positive in other major economies as they are in the US. Consensus forecasts for 2021 CPI inflation in China, the eurozone and Japan are 1.5%, 1% and 0% respectively and trending lower (see Exhibit 1). Data released this week showed China’s latest CPI print at -0.3%, close to a 10-year low.
Exhibit 1: US CPI forecasts are encouraging relative to other major markets
Source: Janus Henderson Investors, Bloomberg, as at 10 February 2021.
So, despite the unprecedented combination of super-charged US fiscal policy and a highly accommodative Fed, the balance of evidence still suggests that it is too early to worry about the risk of the US economy overheating. The enormous US fiscal stimulus will supercharge the recovery this year and next but still seems unlikely to create the sort of inflationary pressures that will force a patient Fed to meaningfully rethink its plans. That seems to be the message that the central bank sent this week.
No free lunch
This prospect of a rapid recovery in US growth, combined with a more gradual increase in inflation, is clearly a very positive backdrop for financial markets. However, given that this optimistic economic scenario is now the consensus view among market participants, it is important to be alert to any threats to this rosy outlook. One general concern worth flagging here is the unusually high level of uncertainty surrounding economic forecasts, given the unprecedented impact of the pandemic and economists’ limited experience in calibrating the impact of coordinated monetary and fiscal policy interventions of the current scale. While consensus forecasts have typically over-predicted inflation since the global financial crisis, the new fiscal policy regime could well be a game-changer here. The possibility of a surprisingly rapid recovery in US wages and inflation is now a risk scenario worth monitoring closely in the US and one that will be increasingly relevant as fiscal stimulus increases.
The big story in financial markets in recent months has been a fairly simple one, of embracing the optimism associated with the vaccines, the reopening economic boom and the supportive policy backdrop. From here, things could get more complicated. If US inflation follows the slow climb higher that most expect, then monetary policy can be normalised at the gradual rate that is priced into financial markets. However, a surprising rebound in inflation would threaten a more abrupt asset repricing, with ominous implications for fixed income markets and inevitable collateral damage to other assets. For now, this is a tail-risk scenario for us, not our central case.