At a glance
- The COVID-19 pandemic triggered an extraordinary fiscal and monetary policy response, which should allow growth to accelerate this year and next. Even as the 1.8 trillion USD American Rescue Plan is signed into law, our analysis suggests the economy would be fully recovered by the end of 2022 without its passing. This creates the potential for economic overheating that could complicate monetary policy.
- While stronger growth is likely to be accompanied by higher inflation, the Federal Reserve views this outcome as transitory and expects to maintain its very accommodative stance for years to come. Moreover, the committee has adjusted its policy framework to support this approach.
- Given the size of expected fiscal stimulus, markets continue to pull forward rate hikes. However, as evidenced by the Fed’s interest rate projections (“dot plot”), the committee isn’t signaling liftoff until sometime in 2024. A fresh set of economic and interest rate projections next week may modify this position.
- We expect the Fed will be prompted by a rapidly improving economy to begin tapering its bond purchases in early 2022. However, this will likely only occur after providing fair warning to markets. For investors, as the Fed begins to ‘think about’ tapering, the yield curve should continue to steepen, reminiscent of the curve steepening experienced during the taper tantrum in 2013.
- Broadly, an accommodative Fed and further fiscal aid should support risk assets into 2022. Thereafter, investors may be well advised to take a more cautious stance in portfolios, as the risks of an overheating economy increase by the middle of the decade.
The Covid-19 pandemic has been a uniquely catastrophic event. Apart from its terrible death toll, attempts to limit its spread triggered a massive global recession and have profoundly disrupted all of our lives. The pandemic would always have demanded a dramatic response in terms of easy monetary and fiscal policy. However, policy responses have been shaped not just by the needs of the present but by the lessons of the past. In the aftermath of the Great Financial Crisis, extraordinary monetary stimulus failed to ignite a strong recovery and thus, indirectly, helped fuel populist movements of both the left and the right, eroding any political consensus in favor of fiscal or monetary moderation. In addition, monetary stimulus and significant fiscal deficits appeared to levy no real penalty in the form of higher inflation.
Consequently, in combatting the pandemic, both the Trump Administration in 2020 and the Biden Administration in 2021, have promoted massive fiscal stimulus. At the same time, the Federal Reserve has enabled this fiscal expansion through continued very low interest rates, multiple lending programs and a significant expansion in their balance sheet. This combination of extraordinary fiscal stimulus and remarkably acquiescent monetary policy should contribute to a very rapid economic recovery. However, it also raises the risk of higher inflation and the potential for a fiscal crisis within the next few years. While equities have reacted positively so far to the prospect of a short-term surge back to full employment, investors will also need to protect themselves against the potential side effects and after effects of extraordinary policy activism.
An unprecedented fiscal surge
Last week, President Biden signed the 1.8 trillion USD American Rescue Plan Act into law. Some of the details of the legislation are outlined in Table 1 below.
Table 1: Major provisions of the American Rescue Plan Act
Source: Congressional Budget Office; Joint Committee on Taxation
This act has the potential to provide far more stimulus to the economy than any other major piece of legislation in modern times, partly because of its sheer size but also because of the speed with which federal money will be disbursed, the distribution of its benefits across different income groups and the timing of its enactment just as the pandemic seems ready to recede.
With respect to the speed with which federal money will be disbursed, Table 2 compares the Rescue Plan Act to the American Recovery and Reinvestment Act which Congress passed in February 2009 in response to the Great Financial Crisis. This year’s legislation, at a 10-year cost of 1.856 trillion USD dwarfs the roughly 789 billion USD ARRA in size. However, equally important, only 23% of the budget impact from ARRA occurred in fiscal 2009. According to CBO estimates, 63% of the cost of the current bill, or 1.164 trillion USD, will be disbursed in the current fiscal year, that is to say, between today and September 30th of this year.
Table 2: The speed of stimulus: Biden 2021 versus Obama 2009
Source: Congressional budget office: Estimated budgetary effects of the American Rescue Plan Act of 2021.
With respect to the distribution of benefits from the plan, analysis from the Tax Policy Center draws a sharp contrast between the American Rescue Plan and the Tax and Jobs Act passed under the Trump Administration. Looking at tax provisions only, as shown in Table 3, the benefits of the Trump tax cuts were most significant in dollar terms for the wealthiest 20% of taxpaying units, who received a tax cut of roughly 7,640 USD in 2018 compared to 60 USD for the lowest-earning 20%. In sharp contrast, the Biden plan provides between 2,800 USD and 3,800 USD in tax benefits for tax-paying units in each of the bottom four quintiles and just 1,900 USD for the top quintile.
Table 3: The distribution of tax benefits: Biden 2021 versus Trump 2017
*Tax cuts includes recovery rebates and earned income, child and dependant care credits.
Source: Taxpolicy center
This can be very significant from a macro-economic perspective, as poorer households have a dramatically higher average propensity to consume relative to their richer counterparts. According to the Commerce Department’s 2019 Consumer Expenditure Survey, the top 20% of households in 2019 saved 30% of their after-tax income while the bottom 80% had a negative savings rate of -6%. This suggests that the tax benefits of the American Rescue Plan are likely to have a significantly greater impact on overall demand that those of the Tax and Jobs Act.
In addition, money paid directly to state and local governments, support for ailing industries, money for school reopening and funding to fight the pandemic should have a relatively immediate impact on aggregate demand.
The economic impact of the American Rescue Plan Act
Analyzing the impact of unprecedented fiscal stimulus on an economy recovering from an unprecedented pandemic recession is, of course, extraordinarily difficult.
However, a good starting point is to recognize that, despite the misery caused by the pandemic, it looks likely that the economy would have returned to close to full health by the end of 2022 even without further fiscal stimulus.
As this is being written we estimate that roughly half the U.S. population has gained some immunity to Covid-19 either through infection or inoculation. The three approved suppliers of vaccines in the United States have promised sufficient doses for all American adults by the end of May. Even allowing for the lags between vaccine delivery, administration and immunity, this suggests that the vast majority of the population should have some immunity by early in the summer, and, assuming no catastrophic problem with variants, the economy and society should be able to get back to normal by the fourth quarter.
This, on its own, should cause a very sharp increase in employment in the retail, restaurant, travel, entertainment and leisure industries. In addition, pent-up demand for these services should push overall output in these areas above levels that prevailed before the pandemic. The 2021 holiday season should see an extraordinary surge in consumer activity to make up for the muted celebrations of 2020.
These higher levels of employment should, of course, finance greater spending as should the wealth effect of recent stock market gains. A synchronous global rebound should also boost the demand for U.S. exports.
Strong job growth should be met by very little additional labor supply, as immigration has slowed to a crawl in 2020 and 2021. This could easily have pushed the unemployment rate below 5% by the fourth quarter of this year and below 4% by the fourth quarter of 2022, essentially returning the economy to full health. In addition, even without further stimulus, the inflation rate, as measured by the personal consumption deflator, could have moved above 2% by April of this year and remained above 2% through 2022.
The American Rescue Plan should allow for an even more rapid recovery than that outlined above, boosting consumer spending, employment and inflation while also adding to the budget and trade deficits.
At their December FOMC meeting, before the passage of the American Rescue Plan or, for that matter, the Georgia Senate elections which had a big impact on the size of the plan, FOMC members forecast that, by the fourth quarter of this year, real GDP growth would be 4.2% year-over-year, the unemployment rate would average 5.0% and the inflation rate, as measured by the personal consumption deflator, would be 1.8% year-over-year.
The net effect of the American Rescue Plan will very likely to result in significantly stronger economic growth, lower unemployment and higher inflation than those forecasts.
Federal reserve: Still dovish despite an improving outlook
From the earliest days of the pandemic, the Federal Reserve has delivered strong policy support to the economy and markets via asset purchases and a commitment to near-zero policy rates. Moreover, in codifying a more dovish approach, the committee officially adopted a flexible average inflation targeting (FAIT) framework, in which it will allow inflation to run above 2% for some time to compensate for periods of inflation undershoots. The Fed also now seeks to eliminate shortfalls from maximum employment instead of deviations from the committee’s perceived level of maximum employment, requiring a much broader assessment of labor market conditions.
In a “normal” economic recovery, this approach would have likely implied an accommodative Fed for many years. In the last economic expansion, the unemployment rate fell for 10 years without generating worrying wage inflation while the core consumption deflator only briefly touched 2% year-over-year. However, massive fiscal stimulus, partially enabled by huge Fed asset purchases, should allow for a much quicker recovery than in previous expansions. As a result, markets have pulled forward expectations of the first rate hike to 1Q23 and expect a full 50bps of increases by early 2024, while the most recent dot plot, from December 2020, suggests the Fed will remain on hold until then (Exhibit 1).
Exhibit 1: Fed pricing of rate hikes being pulled forward
Policy Path (fwd. 1mo. OIS)
Source: Bloomberg, J.P. Morgan Asset Management. The curve represent USD Fed Funds overnight index swaps. Data are as of March 10, 2021.
While markets are getting more nervous about early Fed tightening, the Fed appears determined to maintain dovish forward guidance. The rationale for this stance may be visible in the FOMC projections which will be released in conjunction with this week’s policy meeting. These projections will likely show an improvement to its growth, employment and inflation readings this year, but more modest progress in 2022 and 2023. In the FOMC statement and in Chairman Powell’s press conference, the Fed is likely to stress that it sees further fiscal support and the receding pandemic as providing only a temporary, although powerful, boost to the economy and inflation and not one that warrants an immediate change in policy rates. The median Fed’s dot plot may also emphasize this commitment, although more FOMC members may foresee some rate hike before the end of 2023.
This being said, the Fed is clearly looking to taper bond purchases first if the economy is recovering more rapidly than they anticipate, a reasonable cause of concern for markets. Given the difficulty in forecasting economic variables in the current environment, trying to time the Fed’s balance sheet adjustment is challenging. Nonetheless, we highlight our qualitative forecasts on Fed balance sheet normalization given some broad economic assumptions below:
Table 4: Economic recovery conditions and balance sheet normalization assumptions
In our view, the speed of the recovery is likely to prompt a fairly rapid adjustment of Fed policy over the next two years. The Fed could begin to taper purchases in the first half of 2022, begin to raise the federal funds rate in early 2023 and begin to reduce its balance sheet in early 2024, provided the economy is not threatened by recession by that point.
In the previous expansion, the Fed first began to discuss tapering its asset purchases in May 2013, roughly seven months before it started to gradually reduce its quantitative easing (QE) program. Over that period, the yield curve steepened by 117bps, driven by a 130bp rise in the nominal 10-year U.S. Treasury yields. In similar fashion, recent Fed commentary suggests the committee would provide ample lead time in communicating when they would consider reducing purchases. Given this, we anticipate the committee would begin announce tapering plans at its January 2022 meeting, and reducing purchases in April 2022 following a surge in growth in 2H21. For investors, this will likely lead to further steepening in the yield curve, concentrated in the latter half of this year.
Market impact: The party never ends…until rates become punitive
The recent backup in long bond yields—even if they are rising for the right reasons—has investors concerned about the level of rates that become punitive for stocks. Our long-term analysis suggests the correlation between the weekly changes in nominal long-term interest rates and large cap equity performance begins to turn negative when the nominal 10y Treasury yields rises above 5%. However, over the past decade, the same analysis suggests that the threshold level of rates is closer to 3.0%-3.5%, which seems more realistic given the impact of QE. For investors, we are still far from that point and an improving economy and robust earnings recovery across all sectors should dominate equity market performance over the next 12 months.
The biggest risk to this outlook is the prospect of an overheating economy that could pull forward a tightening in interest rates. However, a more realistic outcome may be a steepening of the yield curve as the Fed attempts to ease up on asset purchases in early 2022. Importantly, the Fed’s commitment to near zero front rates, yet indifference towards a modest back-up in long term yields, suggest it is willing to allow inflation to run hot, a sign of easy policy. This has allowed inflation breakevens, as measured by the difference in the nominal US 10y Treasury and TIP yield, to grind higher since November 2020. Moreover, the more recent prospects of generous fiscal support has allowed growth expectations to improve as evidenced by the rise in real yields.
As highlighted in Exhibit 2, so long as growth remains supported and/or monetary policy remains accommodative, this dynamic should provide a positive backdrop for equities, even if the move higher in real rates is faster than anticipated. With that said, we expect stocks may come under pressure as real yields approach zero and move back into positive territory, after trending negative since mid-2018.
Exhibit 2: S&P 500 returns in various real and breakeven rate environments
%, average S&P 500 monthly excess total return*, Jan. 2003 – present
The combination of extraordinary fiscal and monetary stimulus in an improving economy constitutes the US’s first real experiment with modern monetary theory and it could end in disaster; inflation could meaningfully overshoot as the economy becomes over stimulated from the massive fiscal and monetary stimulus. This could force the Fed to hike rates as soon as mid- to late-2022 and institute an immediate pause in asset purchases which would likely lead to a spike in rate volatility and a selloff in risk assets. On the other hand, the pandemic may have caused unforeseen scarring not yet evident or new variant COVID-strains could possess some immunity to approved vaccines. As a result, employment growth could stall, reflation would be replaced with disinflation, and the Fed may be tasked with trying to do even more, rather than less. While our base case lies between these extremes, we thing the former is the greater risk.
All things considered, the Fed still believes the economy is a long way away from both its employment and inflation goals. This should keep rates firmly anchored at the front end, while a gradual reduction in asset purchases should allow long term yields to gradually grind higher. Therefore, investors should be positioned for steeper curves in the months ahead. Within portfolios, an overweight to equities versus bonds, and shortening duration within fixed income portfolios seem appropriate. Furthermore, greater exposure to credit sectors like high yield and emerging market debt can help fill the income void.