The US economy is ready to party – will there be an inflation hangover?
An effective rollout of the vaccine in the United States has paved the way for what is shaping up to be a spectacular economic holiday in the second half of the year. Americans are emerging from a harsh winter eager to make up for lost time and thanks to a cocktail of household savings and generous tax incentives, this holiday could continue into the night. The big question for the second half of the year is how much of this shows up in real economic growth, or if it leaves policymakers with a lingering headache over inflation. The answer will have a big influence on what happens in the bond and stock markets.
While the aggregate numbers mask the hardships felt by many, the amount of excess savings that the American consumer has accumulated is vast. With households forced to stay at home last year, their spending options were limited and spending therefore plummeted. At the same time, incomes were supported by generous unemployment benefits and “stimmy” checks which caused the amount saved to soar well above normal levels. Indeed, a family of five with a total income of less than $ 150,000 (£ 105,851) received checks in the amount of $ 7,000 (£ 4,939). The results are staggering – the American consumer has put aside more since the start of the pandemic than in the previous three years.
Such an unusual pattern of tight spending due to lockdowns and budget support has led to wide disagreement among economists about the implications for growth and inflation going forward. The short-term pick-up in growth and inflation is a given, but forecasts show that towards the end of the year there is a large dispersion in the forecasts. So what mix of real growth and inflation will the recovery generate?
Much will depend on the extent to which accumulated savings allow consumers to go out and spend. Some caution that savings are concentrated in higher income groups who historically have a lower marginal propensity to spend. But perhaps traditional economic theory is insufficient here given that consumers have been strength save, rather than to choose to save. All indications from recent retail sales and employment reports suggest that demand is extraordinary and that growth in the hardest hit industries is now leading.
While it seems clear that demand is strong, the effect on the economy’s supply is more uncertain. There are significant disruptions in manufacturing supply chains, including a shortage of semiconductors, rising transportation costs, and higher raw material prices. How transient these bottlenecks are remains to be seen, but it seems complacent to rule out the possibility that they persist.
There are also pricing pressures in the service sector and companies are struggling to rehire workers. The $ 300 per week of enhanced UI, in addition to an average regular payment of $ 320 per week, means that at least half of those currently receiving benefits are in better financial condition without a job. Enhanced support expires in September, leaving companies with a dilemma. Are they paying more to hire now to meet the growing demand for the takeover, or are they waiting for benefits to expire and hoping to rehire employees then at a lower cost? We suspect that given the strength of demand, many companies will be forced to pay.
The US Federal Reserve (Fed) has indicated that it would welcome an inflation overrun in the near term. Preventive policy tightening to avoid inflationary pressures seems to be a thing of the past – the Fed has pledged to only hike rates once full employment is reached and inflation is on target and on track to moderately exceed. This explains why the Fed intends to view the current pick-up in inflation as transient and still conducts $ 120 billion in quantitative easing every month, in a year when the economy could grow at its fastest pace. since the 1980s.
This raises the possibility that together the Fed and Washington have made the policy a little too strong and could end up with an inflation headache. If the incoming data begins to raise question marks around the Fed’s assumption that inflation is transient, then Treasury market volatility could increase as investors try to reassess the implications for the Fed ahead. possibly tighten more aggressively to regain control.
How should investors prepare for the party? With inflationary risks appearing to be on the rise, we think it makes sense for investors to be relatively light over the life of the portfolios. The prospect of higher Treasury yields should support cyclical and value stocks as these styles tend to outperform in this environment. Conversely, sectors of the market that have been supported by low Treasury yields could experience difficulties. For those who can withstand liquidity constraints, it might make sense to diversify portfolios with real assets that have low correlations to bonds and stocks and can provide some protection against inflation – infrastructure assets are an example in this regard.
For now, the music continues to play, but investors should be aware of the risks that a persistent return of inflation could dramatically change the mood of the party.
Ambrose Crofton is Global Markets Strategist at JP Morgan Asset Management