‘Generous’ Covid stimulus could overheat economy

Will Joe Biden’s fiscal stimulus overheat the American economy? Photo by Patrick T. FALLON / AFP

On January 20 Joe Biden entered the White House during an economic crisis for the second time. On January 14 he unveiled his plan for dealing with the downturn wrought by the pandemic. Viewed from the bottom up, it combines vital spending on vaccines and healthcare, necessary economic relief and other, more debatable handouts. Seen from the top down, it is a huge debt-funded stimulus. Biden’s plan is worth about 9 per cent of pre-crisis GDP, nearly twice the size of President Barack Obama’s spending package in 2009. And it is big, too, relative to the shortfall in demand that America might suffer once it puts the winter wave of COVID-19 behind it, given the stimulus already in place.

A natural question to ask, then, is whether the proposal, admittedly an opening gambit in a negotiation with Congress, might overheat the economy if implemented. The most prominent figure to warn that this may happen is Larry Summers of Harvard University. His criticisms are notable both because he was an adviser to Obama and because he was hitherto perhaps the world’s foremost advocate of deficit spending. “If we get COVID-19 behind us, we will have an economy that is on fire,” he said on January 14.

There are three main reasons to suspect overheating might be on the cards: emerging evidence that the downturn may prove temporary; generous stimulus; and the Federal Reserve’s monetary policy strategy. Take first the evidence that today’s downturn might be more temporary hiatus than prolonged slump. The number of non-farm jobs remains around 10 million, or 6.3 per cent, below its pre-pandemic peak — similar to the shortfall seen in 2010. Yet after the first wave of infections last year, unemployment fell much more rapidly than forecasters expected.

If job creation were to return to the average pace achieved between June and November 2020, the pre-pandemic peak in employment would be reconquered in less than a year. It was not until midway through Biden’s second vice-presidential term that such a milestone was reached last time.  Bolstering the case for a rapid rebound is the fact that economic disruption appears concentrated in certain sectors, rather than spread widely. America shed jobs overall in December, but only because the leisure and hospitality industries were hit by social distancing. The ratio of job openings to unemployed workers remains high and, outside the affected sectors, wage growth has not fallen much. The shortfall in spending is also concentrated. Consumer spending in the week to January 3 was down by just 2.8 per cent compared with a year earlier, according to Opportunity Insights, a research group. Yet retail spending on goods was 16.5 per cent higher; it is restaurants, transport and entertainment that are in trouble. And stimulus has more than made up the disruption to incomes in 2020. In November Americans’ total after-tax income was 4.3 per cent higher than a year ago.

Indeed, the arithmetic of stimulus is a second reason why the economy may heat up. Before December, total fiscal stimulus in 2020 amounted to almost $US3 trillion ($3.9 trillion) — about 14 per cent of GDP in 2019 — much more than the probable fall in output. Social-distancing measures meant that much of this cash piled up in bank accounts. According to Fannie Mae, a government-backed housing-finance firm, by mid-December Americans had accumulated about $US1.6 trillion in excess savings. It is hard to know what might happen to this cash pile; economists typically assume that households are much less likely to spend wealth windfalls (such as the gains from a rise in the stockmarket) than income. But if people instead regard these excess savings as delayed income, then the cash hoard represents stimulus that has not yet gone to work, to be unleashed when the economy fully reopens.

In December then president Donald Trump signed into law ­another $US935bn of deficit spending, which extended unemployment benefits, provided more support for small firms, and sent most Americans a cheque for $US600. This ensured that lost income would continue to be replaced. Biden’s proposed $US1.9 trillion of stimulus, which includes another $US1400 in cheques, would make the total fiscal boost in 2021 roughly equal to that in 2020.

Jason Furman, another former Obama adviser, calculates that the combined impact of the December package and the Biden plan would be about $US300bn per month for the nine months in 2021 for which the measures will be in effect. By comparison, the shortfall in GDP, compared with its pre-crisis trend, was only about $US80bn in November. Typically, Keynesians argue fiscal stimulus boosts the economy because of a sizeable “multiplier” effect. But the case for the stimulus to be as large as Biden’s proposal “has to be that you think the multiplier in 2021 is really small”, says Furman. Otherwise, it seems destined to take total spending beyond what it can produce next year, resulting in a burst of inflation.

Were the economy to show signs of such overheating, the Fed might typically be expected to raise interest rates to cool things down. Indeed, since January 6, when the Democrats won the crucial Senate seats in Georgia that might allow them to pass a big stimulus, the 10-year Treasury yield has risen from about 0.9 per cent to around 1.1 per cent. The yields on inflation-linked bonds have risen roughly commensurately, suggesting that bond investors have been expecting higher real interest rates, rather than just higher inflation. But the Fed is tripping over itself to signal that monetary policy will remain loose — a third reason to expect overheating. The time to raise interest rates is “no time soon”, said Jerome Powell, its chairman, on January 14. He also pooh-poohed the idea that the Fed might soon taper its $US120bn monthly purchases of Treasuries and mortgage-backed securities. Mr Powell says the Fed has learned the lessons of 2013, when its hints that it might taper asset purchases sent bond markets into a tizz. Monetary policymakers still say that preserving “smooth market functioning” is one of the goals of their purchases, even though bond markets have been calm since the spring.

The Fed is so willing to keep the pedal to the metal because, in contrast to the recovery from the GFC, it is seeking to overshoot its 2 per cent inflation target, in order to make up for continuing shortfalls. The strategy, announced last year, is still being digested by investors. It is unclear whether policymakers are committed to “average inflation targeting” as an end in itself, or simply as a means to stop inflation expectations from slipping too much during the downturn, argues David Mericle of Goldman Sachs. Given that inflation expectations have risen recently, that distinction might prove important. Regardless, the Fed has been clear that it will not raise rates until inflation is “on track to moderately exceed 2 per cent for some time”.

Those zealously committed to breaking the world economy out of the low-rate, low-inflation trap of the 2010s might welcome the even larger burst of inflation that the current policy mix could enable. The Fed is not in that camp. Were overheating to provoke it into earlier rate rises than markets expect, the assumption of cheap money that underpins today’s sky-high asset prices and the sustainability of rocketing public debt might begin to unravel.

Such a scenario remains a tail risk. The most likely outcome is that Congress agrees on a smaller stimulus than Biden has proposed, and that overheating, if it occurs, proves temporary.