Friday's Market Minute: Another Fiscal Jolt Might Cause Economy To Overheat

Economic activity is picking up faster than many expected, and the recovery poses challenges for central bankers. They must find a way to unwind the accommodative measures and avoid an unwanted recession further down the road. The Federal Reserve has repeatedly signaled it would look through any short-term rise, focusing instead on whether inflation can sustain above 2% as measured by personal consumption expenditures before tightening monetary policy. The near-term outlook for inflation continues to suggest a temporary spike, reflecting an adjustment in higher price levels. The spike was caused by price changes driven by consumer-spending shifts related to the pandemic and supply-chain bottlenecks.

One potential catalyst for overheating comes from the Fed’s accommodative stance. The Fed signaled that it intends to keep the asset-purchases in place for a while and the federal funds rate at the lower boundary. As such, stronger than expected economic growth coupled with stationary monetary accommodation may lead the U.S. economy towards another cycle of uneconomic investment derived from the cost of financial capital well below the actual productive return on investment.

Besides generous monetary accommodation, President Joe Biden is set to unveil a budget that would increase federal spending to $6 trillion in the coming fiscal year with annual deficits of more than $1.3 trillion over the next decade. Relative to GDP, this would translate into the highest amount of federal spending since World War II. Spending predictions assume consumer prices will never rise faster than 2.3% per year, and a quickly rebounding labor market with unemployment falling to 4.1% by next year and remaining below 4% over the rest of the coming decade. This latest news marks another rare confluence of accommodative fiscal and monetary policy, which may once again manifest into higher inflationary concerns. Taking history into consideration, unlike previous shocks, economic weakness in 2020 was not due to excessive indebtedness within the system. Rather, household, corporate, and financial sector balance sheets are much healthier than in prior post-recession periods.

While the pandemic triggered unprecedented challenges, the economic recovery needs to be carefully addressed. Investors have experienced such a prolonged era of benign inflation prior to the pandemic that portfolios may still be underprepared for even relatively modest changes in both inflation and inflation expectations. The risk of an overheating U.S. economy is real, and inflation does not just carve away consumer purchasing power, it also erodes the value of investment returns over time.

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