As the latest COVID-19 relief bill winds through the U.S. Congress, some economists have been warning that too much stimulus could lead to the economy overheating. These economists have even alluded to rising risks that inflation returns to levels not seen since the 1970s, which could force the Federal Reserve to hike rates much sooner than many expect – perhaps as early as next year.
However, we believe the practical risks of a 1970s-style inflationary episode are relatively low even if the size of spending is large compared with the current size of the output gap. Structural changes in the U.S. economy over the past 50 years, most notably lower labor bargaining power, have reduced the likelihood that history repeats itself. (For details, see our recent blog post on U.S. fiscal policy and inflation risk.) Our view is also consistent with the recent price action in bond markets. While real yields have moved higher – likely driven by an improved growth outlook and additional expected fiscal stimulus – longer-tenor breakeven inflation spreads are pointing toward inflation at the Fed’s longer-run target, not suggesting a worrisome rise in inflation expectations.
Yet that is not to say that we do not see other risks to the U.S. recovery. We would argue that financial stability risks could rise further. With an estimated $1.1 trillion in excess savings currently sitting in checking and savings accounts, it is possible that some of that money finds its way into financial markets, further stretching valuations. This, compounded with other concerns, reinforces our view that macroprudential policies will likely tighten over the next few years. To ameliorate these risks, the Fed would likely only raise rates as a last resort. Nonetheless, the bigger point is that being overly focused on inflation concerns may miss issues around financial stability that have a greater likelihood of affecting markets.
The output gap and savings
According to PIMCO’s estimates, which incorporate our view that the fiscal multipliers will be more muted due to pandemic-related restrictions, we expect the U.S. output gap to close by year-end, and for output to exceed potential modestly in 2022. This forecast suggests we could see a return of a roughly 3.5% unemployment rate, which we think will be offset to some extent by labor supply improvements as individuals who dropped out of the labor market return, and is consistent with some moderate above-target inflation.
Embedded in our output gap forecast is also the assumption that consumers won’t spend the brunt of their excess savings, at least not right away. The cumulative excess savings, based on National Income and Product Accounts (NIPA) measurement, is around $1.6 trillion, and the Fed’s Financial Accounts suggest that most of that money is currently sitting in checking and savings deposits. These estimates of excess savings don’t account for unpaid mortgage principal from forbearance, which Black Knight estimates to be worth around $500 billion. Nonetheless, adjusting for that, excess savings of $1.1 trillion is still large.
While it is possible that this money could be spent quickly, we believe the more likely outcome is that it finds its way into real estate investment and/or financial markets. This has already started to happen to some extent. The Fed’s Financial Accounts show the pickup in residential investment coincided with a decline in savings account deposit flows. This pattern also can be seen in household equity holdings, although the magnitude is less. This view is based on two observations.
First, historically, after recessions, the savings rate tends to remain somewhat elevated relative to its pre-recession level. Indeed, out of the last eight recessions, only two of them – 1981 and 1974 – ended with the savings rate below its pre-recession level, according to NIPA.
Second, and more importantly, the Fed’s Distributional Financial Accounts suggest that the excess savings is concentrated on the balance sheets of wealthy households. Indeed, about two-thirds of this $1.1 trillion is held by the top 10% of wealthiest households. This same top 10% group is estimated to account for 90% of equity holdings in the U.S., according to a 2016 report by the Minneapolis Fed. Even though fiscal stimulus has been highly targeted to lower-income households, it has served to offset job losses that disproportionately affect these same households. In other words, these high-propensity-to-consume households likely spent the lion’s share of their federal government support payments last year.
Financial stability risks “notable”
If this money finds its way into financial markets, it’s possible that it exacerbates financial stability risks. The recent social-media-driven price action in single name stocks, although not systemic, offers a clear example of the potential boom-and-bust behavior that could ensue. And this, coupled with other concerns, could compound the risks to financial stability.
Fed officials have recently raised their assessment of financial stability risks. At the January Fed meeting, the staff characterized the vulnerabilities as “notable” instead of the “moderate” description used in the November financial stability report, citing elevated valuations of corporate bonds, equities, and industrial and multifamily properties; poor balance sheets of small and midsized business; and worrisome leverage at hedge funds. Furthermore, the Fed’s semiannual monetary policy report released on February 19 discusses “significant structural vulnerabilities” for money market and mutual funds and argues that “without structural reforms, the vulnerabilities demonstrated in March 2020 will persist and could significantly amplify future shocks.”
Macroprudential policy will probably get tighter
All of this suggests that macroprudential policy is likely to get tighter. There are several areas where the Fed could tighten policy, including increasing the severity of its stress tests. However, the Fed can’t mitigate these risks alone, and we would also expect other regulatory agencies to focus policy proposals on combating the perceived vulnerabilities. The Financial Stability Board recently released its assessment of the policy implications of last year’s market turmoil, suggesting that actions should be taken to reinforce the resilience of non-bank financial intermediaries and assess market participants’ ability to meet margin calls. Mitigating excessive leverage in funds that invest in core bond markets is also being mentioned. (Read PIMCO’s recap and lessons learned from the March 2020 turmoil.)
Fed funds rate is the last resort
What if inflation hawks are right about the rising risk that the Fed hikes rates in 2022, but for the wrong reasons? As then Fed Governor Jeremy Stein famously stated in 2013, tightening monetary policy by raising the fed funds rate “gets in all the cracks.” And Fed Governor Lael Brainard remarked in 2015 that the Fed has more “limited macroprudential tools relative to some other central banks,” necessitating a “richer discussion” of “the role of financial stability considerations in monetary policy.”
To be sure, we would characterize this policy as a last resort. And at the press conference for the January 2021 Fed meeting, Chair Jerome Powell asserted that using monetary policy to address financial stability risks was not something they had theoretically ruled out, but something they’ve never done and not something they would plan to do. Nonetheless, the bigger point is that being overly focused on inflation concerns may miss issues around financial stability that have a greater likelihood of impacting markets.
For insights on U.S. inflation, please read this recent blog post: “Fiscal Spending Could Cause a U.S. Growth Spike – Compounding Investors’ Concerns on Inflation.”
Tiffany Wilding is an economist focused on North America and a regular contributor to the PIMCO Blog.