The Pandemic Crisis and the Policy Reaction
In most decades, there are dramatic events that interrupt the course of history and the last twenty years have seen at least three obvious examples of this. However, more often than not, it is the reaction, in public attitudes and policy, rather than the event itself, that shapes the path taken by society in its aftermath. The horror of 9/11 laid the groundwork for wars in Afghanistan and Iraq. The global financial crisis led to an era of much tighter oversight of financial institutions that, in turn, curtailed lending, contributing to the slowest economic recovery in modern U.S. history.
Similarly, despite the unprecedented suffering caused by the pandemic and the 2020 recession, it is the reaction to this crisis, more than the crisis itself, that will likely shape economic fortunes and investment returns in years ahead. In particular, the odds are rising that huge fiscal stimulus, enabled by very easy monetary policy, will lead to very rapid economic growth as the pandemic winds down. This should help speed the end of the pandemic, provide much needed support to millions suffering economic hardship and lead to a remarkably fast economic recovery. However, it also carries with it the risk of overheating the economy and, by boosting inflation and long-term interest rates, precipitating a mid-decade fiscal crisis which could threaten the economy with both renewed recession and higher taxes.
Both the crisis and the policy reaction will be on full display in the week ahead.
The most important numbers will be those of the pandemic. It should be emphasized that there are some positive signs. New confirmed cases, test positivity rates, hospitalizations and deaths have all fallen recently as the damage from holiday season gatherings gradually abates. We also have two approved vaccines and there are hopeful signs of good news on a third within the next few weeks.
While vaccinations are not proceeding nearly as fast as the situation demands and scientists are getting concerned about new variants of the disease, the odds still favor a winding down of the pandemic over the summer since, by the end of July, the vast majority of American adults will have either received a vaccine or gained some degree of immunity by contracting the disease. However, for now, the death toll remains frighteningly high, with more than 20,000 Americans dying from Covid-19 in just the last week. The need for more resources to combat the pandemic is obvious.
Economic numbers in the week ahead will also highlight the damage being caused by the renewed pandemic. In particular, while fourth-quarter GDP may have grown by more than 5% annualized, momentum slumped over the course of the quarter as witnessed by the fall in December employment and retail sales. This should be confirmed by a decline in overall consumer spending in December as well as still very elevated unemployment claims for the most recent week.
This clearly very difficult situation, along with a change in administration and narrow Democratic control of Congress, makes a strong fiscal response very likely. The former Fed Chair, Janet Yellen, is likely to be confirmed as Treasury Secretary on Monday. In her confirmation hearing testimony last week she made it clear that her first mission will be to help President Biden pass his rescue plan and she has no qualms about the size of the package. In her words, “…with interest rates at historic lows, the smartest thing we can do is act big”.
This view could get important support from the Federal Reserve at this week’s FOMC meeting. While the Fed is unlikely to make any further policy moves at this time, they will likely acknowledge the drag on the economy from the resurgent pandemic. In addition, in his press conference, Jay Powell will undoubtedly be asked about President Biden’s $1.9 trillion recovery package. While trying to stay above the political fray, based on his previous comments, the Fed Chair is likely to endorse the idea of further fiscal stimulus.
From a political perspective, President Biden would dearly like to pass a stimulus bill with bi-partisan support, including the 60+ Senate votes needed to avoid a filibuster. However, it is very doubtful that there are 10 Republican Senators who will sign on to anything like the $1.9 trillion bill he has suggested. So, having made some compromises to try to secure at least a few Republican votes, it is likely that Democrats will push something close to the President’s proposal through the House and Senate using the reconciliation process in the next few weeks.
In the short run, this should support the economy over the next few months. However, by the fourth quarter of this year, stimulus from this package, possibly combined with further deficit spending in a recovery and infrastructure plan and the unleashed pent-up demand of consumers should lead to a sharp acceleration of real economic growth to a high single-digit pace, a dip in the unemployment rate to below 5% and an inflation rate exceeding 2%.
In this environment, the Federal Reserve would likely signal a tapering of bond purchases leading to a further increase in long-term interest rates. However, the policy reaction to the pandemic and its recessionary effects will linger leaving fiscal and monetary policy in a still very expansionary mode. As the economy recovers fast, it is likely that this will ultimately lead to further increases in government debt and inflation pressures. For long-term investors, it is important to recognize that this will likely end with higher interest rates and taxes.
In the coldest days of winter, many people buy summer clothes, partly in denial of the current weather but also in recognition that they need to be prepared for a different climate. Similarly, despite the toughest of times today, investors should consider valuations carefully and make sure their portfolios are able to adapt to a much warmer environment but one in which super-charged fiscal and monetary stimulus may be seen in a less favorable light than today.