The Biden administration’s USD 1.9 trillion-stimulus proposal is large – amounting to 9% of US annual GDP – and redolent of the October, pre-election speculation about a massive ‘Blue Wave’ fiscal package to help the economy – principally households and small businesses – deal with the effects of coronavirus-related restrictions and lockdowns.
Whether a finely balanced Congress will go along with every element President Joe Biden has proposed, and in the scale he wants, remains to be seen, but there is clearly Democratic backing for the overall idea of significant government aid spending.
Elements such as the USD 1 400 stimulus cheques will carry some Republican support, and President Biden would ideally like to pass the package with bipartisan backing. That would require at least 10 GOP senators supporting it. However, if bipartisan support is not forthcoming in the next few weeks, Democrats will plough on alone.
Over Christmas, Congress passed a USD 900 billion (4.3% GDP) stimulus package, one of the largest-ever fiscal expansions. The idea of adding USD 1.9 trillion-stimulus bill on top, with the prospect of a potential infrastructure spending package still to come, demonstrates how there has been a 180-degree pivot from the austerity thinking that was commonplace immediately after the Global Financial Crisis.
To illustrate this point, spending worth in total 13% of GDP would almost equal what was spent in 1917 after the US entered World War I (Exhibit 1). In contrast, the stimulus the Obama administration passed early in 2009 cost a cumulative 5.5% of GDP over six years, with peak spending in 2010 worth just 2.7% of GDP.
Clearly, stimulus of the sort Biden’s team is pushing should have significant implications for the outlook for US growth relative to the rest of the world, the US labour market and the balance of payments.
Unsurprisingly, financial markets have reacted: the 10-year US government bond yield has risen by about 25bp since November’s presidential election, with the majority of that having come since the first serious talk of a Christmas stimulus package. Some further modest upward pressure on yields is likely in the near term as Biden’s stimulus proposal works its way through Congress.
However, if one steps back, the big question is: if this is the biggest peacetime stimulus package in history, why hasn’t the bond market reacted more aggressively? The answer is inflation. Or rather the perceived lack of it.
To put things into context, the Federal Reserve’s monetary framework has two parts. The central bank has said it will taper its quantitative easing (QE) asset buying when there has been ‘substantial further progress’ in the economy.
Exactly what constitute such progress the Fed has not clarified, but it is likely to rest heavily on repairing the damage to the labour market. Massive fiscal spending will speed that process along.
The Fed’s economic forecasts presented in December preceded the passage of the Christmas stimulus package, yet foresaw above-consensus GDP growth in 2021 of 4.2%, bringing the unemployment rate down to 5%.
When policymakers sit down to update those forecasts in March, they will likely need to substantially upgrade them, quite possibly to a level that leads more central bankers to speculate that the conditions for tapering QE will be met this year despite efforts from chair Powell to damp down such talk.
Tapering QE this year – if it happens – because of a significant improvement in the labour market may tell you little about when the Average Inflation Targeting framework will dictate the first rate rise should be. That depends on when inflation finally turns up, in particular, as Fed vice chair Richard Clarida outlined last week (see The Federal Reserve’s New Framework: Context and Consequences, 13/01/2021) when (core) inflation has been at above 2% for a year.
Until proven otherwise, the Fed (and likely many/most bond investors) will continue to think that:
Indeed, while far from a perfect indicator, it is noteworthy that even in those countries that have performed best in controlling COVID (exhibit 2), core inflation is currently low, and in some cases, very low, demonstrating the global downward pressure on inflation.
That leaves the market pricing in extremely low real rates, driven by the difficulty of pricing a first rate increase before 2023.
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