For the 3rd time now, the US government has been sending out stimulus checks to many citizens as a relief for the economic downturn that the Corona pandemic has created. While some have classified this as helicopter money, this is technically not quite correct. The idea of helicopter money originated with Milton Friedman who argued that in an economic downturn when interest rates are at zero, the Central Bank could just reinflate the economy by literally dropping money from the sky. This would raise inflation, but more importantly, also boost nominal incomes.
One could argue that the combination of fiscal stimulus checks plus Quantitative Easing by the Central Bank (creation of additional bank reserves) comes relatively close. However, QE can be reversed while dropping money from the sky cannot.
Regardless, the combination of fiscal stimulus checks plus the Fed’s QE have done their part in stimulating the economy. Long-term inflation expectations dropped early this year when the economy shut down this spring.
Consequently, the Fed almost doubled its balance sheet over the course of one year, including its holdings of US Treasuries. At the same time, US debt levels have increased by an unprecedented amount.
Long-term inflation expectations based on the TIPS spread have therefore increased to what they were before the downturn and the dollar is depreciating, which adds to inflationary pressures. Arguably, the Corona pandemic has damaged the supply side of some sectors. Combined with the all the fiscal and monetary stimulus, there are now renewed fears of an inflationary spike this year. However, I would say that this is unlikely to happen for several reasons. First, unemployment is still quite high and economic growth remains sluggish. As the US economy might not recover to its previous peak until early 2022, inflationary pressures are unlikely to happen when output gaps are that large.
The AIT framework looks more and more credible
With the new AIT framework, the Fed actually wants inflation (and nominal incomes) to overshoot at times. Fears that inflation is hard to control are misguided as sufficient interest rate hikes can put a lid on inflation beyond what the Fed is trying to accomplish. Over the course of 2020, the Fed balance sheet almost doubled from less than 4 trillion USD in early 2020 to now more than 7.5 trillion USD to fight the economic downturn resulting from the Corona pandemic.
Market-based measures of inflation expectations (TIPS spread) first plunged in spring and then recovered later on this year. Moreover, the dollar has been depreciating at first, showing that the Fed’s reflationary efforts seem to work.
With the US Treasury sending out checks to most US citizen, the Fed’s money printing plus fiscal stimulus is as close to Milton Friedman’s idea of helicopter money as one can get right now, without actually doing it.
The size of the fiscal impulse is completely unprecedented and has reached a level not seen since World War II. Moreover, the US is one of the countries where household disposable income is actually now significantly above trend while GDP is still below trend.
This divergence between disposable income and GDP is of course also entirely unprecedented and will most likely lead to some pent-up demand in the coming one or two years, as households will decide to run down some of the accumulated savings. Therefore, it is not surprising that economic forecasters are now expecting the US economy to recover much more quickly than European countries.
First, the US fiscal and monetary impulse has been so large that nominal GDP might grow by some 8-10% this year, a rate that has not been reached since the 1980s. Second, the US vaccination is progressing at a much faster pace, which will give a boost to the supply side.
Considering a wide range of data for inflation expectations, the TIPS spread, 5-year forward, Cleveland Fed inflation expectations, short-run inflation is expected to increase beyond 2% whereas long-term inflation expectations seem to be anchored around 2%. After many years of undershooting the target, this is precisely the outcome the Fed is hoping to achieve with its new AIT (Average inflation targeting) framework. For the first time in a longer time, Central Bank policy looks very credible.
Looking at more recent statements, one can see that the Fed has also changed its view on the labor market, emphasizing shortfalls from maximum employment instead of deviations from full employment. This also reflects a fundamental change because it rejects the standard neo-keynesian assumption that emphasizes fluctuations around a natural rate. This view of the world was and always has been extremely problematic since booms and busts are simply not symmetric, no matter how hard you try and hide that fact with dubious assumptions. A world in which output rarely exceeds potential but falls below potential during recessions, Milton Friedman’s plucking model, always made more sense, and it now seems that the Fed agrees.
The Dot Plot looks slightly off
According to the Dot Plot, FOMC members are currently not seeing any need to increase rates before 2023. After being wrong for almost a decade in the opposite direction, I now think that the Fed is a little too pessimistic and market forecasts have now priced in earlier rate hike for the beginning of 2022. Given the strength of expected NGDP growth in 2021, this seems more plausible to me. As inflation will go up, long term yields will also rise even further on top of the recent increase.
This is not a problem though. I see it now very likely that the US economy will have a nominal income boom in 2021/2022, but this is precisely what is needed after more than a decade of meagre growth. Moreover, the current policy prescriptions are precisely in line if you think that secular stagnation has been the most important Macro problem of our times. So I have literally no idea what Summers and Blanchard are currently talking about.
It will be quite easy for the Fed to hike rates once inflation is approaching or starting toe exceed some 3%, and they should overlook the temporary surge that is bound to happen with commodity prices rising right now.
While a succession of rapid rate hikes might hurt some bond holders down the line, it is not clear at all why the Fed should care, and it will also have little impact on macroeconomic stability, which is the Fed’s main target. Moreover, with many other advanced economies being stuck at zero-interest rates forever, the US economy will not be able to decouple from globally low rates, or otherwise the dollar would appreciate strongly, which would be a negative for domestic growth.
Therefore, even in the US, we might only see a couple of rate hikes in 2022 even as inflation will modestly overshoot the Fed’s target. There will be a nominal income boom in 2021/2022, but no inflationary boom. Let’s be real, pun intended.
So here my predictions for the record, I will try and revisit them in a year:
US nominal GDP growth:
Certainly, above 8,5%, possibly reaching 10% this year. Going down to some 6% next year.
US CPI yoy change:
Will probably reach some 2.5% later on this year, possibly reaching 3% by end of 2021.
Will probably be just at or under 5% at the end of the year
Despite what the Fed is saying on how they won’t raise rates until 2023, I think they underestimate the strength of the current recovery. Even with the new AIT framework, I now see the first rate in the first half of 2022.
10 year yields:
Will certainly rise within the next two years in order to compensate for higher inflation. Might approach some 2.5%-3% at some point in time next year, consistent with a real interest rate close to 0%.