It is often said that economic forecasts exist solely to make astrology look respectable, but since year-ahead predictions are an age old tradition in the financial community we too shall again partake in this annual exercise. Before looking ahead, though, we should first reflect back on what happened during the past twelve months.
At the start of 2020 we were optimistic that economic growth would continue to gain momentum in the new year, but cautioned that due to the earlier inversion in the yield curve the economy would be more sensitive to an exogenous shock. Well such a shock clearly arrived in the form of a global pandemic, and the resulting abrupt halt to economic activity brought the longest post-WWII expansion in America to an end. However, unlike past recessions that are typically caused by some buildup of imbalances the current downturn was self-inflected, i.e. a forced, nationwide shutdown to curtail the spread of a virus. Given this unique dynamic we maintained a relatively optimistic assessment of the economy throughout 2020, particularly during the H1 tumult when many other analysts were quick to jump on the “depression” bandwagon. Our assessment clearly paid off considering the snapback recovery seen in many areas of the economy, and we maintain this bright outlook for 2021.
To clarify, though, we are not necessarily suggesting that everything will be back to normal (pre-pandemic trendline growth) anytime soon but simply that the broad improvement in activity should continue such that even in the most impaired areas of the economy the incoming data should at the very least further transition from “terrible” to “less bad.” A key question going forward is therefore how much positive momentum can be gained in the new year. The answer depends heavily on two critical issues: government policy and the fight against COVID-19. With respect to the pandemic, the recent influx of positive vaccine news has been encouraging, especially for the service sector which again unlike past recessions has been where the bulk of the weakness has been found this downturn due to its higher concentration of close-proximity businesses more directly affected by lockdowns and other activity restrictions intended to stem the spread of the coronavirus.
Assuming the vaccine rollout goes smoothly, these areas of the economy that remain the most depressed can start to reopen and finally join in on the recovery. Such a scenario of course hinges on several conditions being met, including adequate vaccine supply, sufficient participation from the populous, and no efficacy surprises. If there are no hiccups then the reopening, which has been put on hold by the winter wave of the virus, can resume and even start to broaden. The rebound in activity, though, will likely be a gradual process rather than an instant bounce back to pre-COVID levels. Moreover, once businesses are allowed to operate at full capacity they will probably not rush to rehire 100% of their workforce and instead wait for customer demand to fully return and warrant such staff levels. Things are further complicated by the fact that many companies in 2020 learned to operate with a smaller staff due to pandemic-related restrictions.
This could not only provide another headwind for the employment recovery but also the rebound in broader consumer confidence since labor market views influence household sentiment. In some ways this is actually good news because it means the economy can continue to strengthen in 2021 without a significant risk of overheating. Another important aspect of the recovery worth mentioning is schools being able to reopen. Since the education system provides a crucial daycare service for many prime age workers, a widescale reopening of the schools could free up a lot of labor supply. This will reverse some of the artificial tightness seen in the labor market last year, and in turn help keep wage pressures in check in 2021. We therefore do not see a sharp pickup in inflation occurring during the next twelve months. Price pressures will of course continue to firm in the new year but nothing that would force the Federal Reserve to move on interest rates. Recent FOMC commentary suggests that monetary policymakers share this view.
However, based on the Fed’s latest economic projections we actually appear a bit more optimistic about America’s growth prospects during the next few years and therefore would not be surprised if the federal funds rate lifts off of the zero lower bound ahead of the FOMC’s current (median) 2024 assumption. Something that can greatly influence this timetable is the fiscal component. Indeed, if the next few years see a surge in government spending we may experience a quicker resurgence in inflation. Negative side-effects can in theory be offset by ample economic and productivity growth if the spending is well-targeted, e.g. investment in America’s technological infrastructure, but the government’s history of inefficient budgeting perhaps makes this goldilocks scenario less likely. Regardless, in the near-term a major uptick in fiscal expenditures, outside the scope of any further spending initiatives already being floated in D.C., would probably face several obstacles, such as a divided Congress, assuming of course Republicans can hold onto the Senate in today’s Georgia runoff election.
Under this political scenario it is difficult to expect a substantial increase in government spending in 2021 unless the economy were to deteriorate markedly from current levels, which is not our base case if the vaccine deployment and subsequent reopening proceed without any hitches. Other government issues to pay attention to include trade, taxes, and regulation. If Congress remains divided the likelihood of a reversal of the 2017 corporate tax cuts and other major legislative changes is greatly reduced. The new administration could still exert executive powers to pursue its agenda, but the White House’s economic advisors will hopefully suggest refraining from highly restrictive business regulations while many areas of the economy are still in recession. As for the trade issue, the new administration may try to rollback many of the policies of the past four years. Although this could hurt America’s long-term global competitiveness it means that at least for the time horizon of this outlook a renewed trade war is unlikely to be a headwind for the recovery.
Altogether we believe that the future remains bright for the U.S. economy, particularly from a long-run growth standpoint, but at the same time we acknowledge that a lot of unknowns continue to cloud the near-term outlook. Further, as we alluded to above many of the more optimistic scenarios for 2021 depend on a lot of things all going right during the next few months, and by some measures the economy is also more exposed now to an exogenous shock than it was at the start of 2020. All of this means that even if conditions are greatly improved a year from now it will not necessarily have been smooth sailing for the economy (and the stock market) throughout 2021. However, if in need of some reassurance should periods of heightened uncertainty return, it is important to remember one of the key lessons of 2020: governments and central banks across the globe will step in when needed the most, and it is hard to see this changing anytime soon.
**01/06 update following the result of the Georgia runoff election: Since the Democrats' newfound control of Congress is held by a razor thin margin any major fiscal packages, beyond the scope of the measures that found bipartisan support in Washington last year, could still require a lengthy negotiation process, and after that the presumed inflationary side-effects would take a while to even begin showing up in the data. As a result any additional upward pressure on consumer prices resulting from an acceleration in government spending this year will probably not be enough to force the Federal Reserve to raise rates in 2021. 2022 and beyond, though, is when the potential for more meaningful inflation, and other legislative risks, could pick up. Altogether this is why the power flip in the Senate has yet to materially change our 2021 rates outlook, and if anything the runoff outcome strengthens our argument that the Fed will likely have to hike ahead of the median FOMC member’s 2024 expectation. More importantly, as influential as last night's election outcome could be in the year's ahead, the fight against the pandemic remains the more pressing issue for the country at the moment, and this will remain the case until the economy has fully reopened.
Sources: Federal Reserve Board of Governors
Post author: Charles Couch