Elections, vaccine, and virus resurgence all key risks - Capital Economics
US Economics

Elections, vaccine, and virus resurgence all key risks

US Economic Outlook
Written by Paul Ashworth

Following a 3.7% decline this year, we expect GDP growth to be a solid 4.5% in 2021, but the risks to that forecast on both sides are, frankly, enormous. The key downside risk is that recurring waves of coronavirus infections during the winter flu season prompt more economy-damaging lockdowns. The key upside risks are that an effective vaccine becomes widely available early next year or that, post-election, the new Congress agrees on another major fiscal stimulus.

  • Overview – Following a 3.7% decline this year, we expect GDP growth to be a solid 4.5% in 2021, but the risks to that forecast on both sides are, frankly, enormous. The key downside risk is that recurring waves of coronavirus infections during the winter flu season prompt more economy-damaging lockdowns. The key upside risks are that an effective vaccine becomes widely available early next year or that, post-election, the new Congress agrees on another major fiscal stimulus.
  • Consumer Spending – The initial post-lockdown recovery in consumption was impressive but, with the enhanced unemployment benefits expiring and ongoing physical distancing restrictions still weighing on services spending, consumption growth is already losing momentum. Nevertheless, spending should return to its pre-pandemic level by the middle of next year. We expect real consumption to rebound by 5.5% in 2021 and 4.0% in 2022.
  • Investment – Low interest rates are contributing to a strong rebound in investment which, after declining by 3.4% in 2020, we expect to rebound by 4.0% in 2021. But that masks a big divergence among the different components of investment, with prospects for residential property brightest.
  • External Demand – The strong rebound in domestic goods demand has blown out the trade deficit, but with demand overseas also now picking up and the dollar weakening, we do not think that marks the start of a sustained deterioration in the current account.
  • Labour – The recovery in employment is likely to continue lagging, as weakness in labour-intensive sectors like leisure and food services provides an ongoing drag. Nevertheless, we still expect the unemployment rate to continue falling, which will limit downward pressure on wage growth.
  • Inflation – The initial impact of the pandemic was sharply deflationary, but prices have already begun to rebound and several unique factors mean that inflation is likely to recover more quickly than in past cycles. We forecast that CPI inflation will average 2.5% next year, although that is partly because of base effects linked to the temporary price falls earlier this year. Inflation will drop back a little in 2022.
  • Monetary & Fiscal Policy –With monetary policy close to its limits, any further significant stimulus would have to come from the fiscal side. The chances of a pre-election package are now close to zero but, depending on the outcome of the upcoming elections, there is still the possibility of additional fiscal stimulus sometime next year.
  • Long-term Outlook – The pandemic could change the long-term economic outlook in a number of ways, but the most obvious shift is that the higher public debt burden will necessitate even lower interest rates for longer than we previously anticipated.

Key Forecasts Table

Table 1: Key US Forecasts

% q/q annualised

2020

2021

2022

Annual (% y/y)

(unless otherwise stated)

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

2020

2021

2022

Demand

GDP

-5.0

-31.4

30.0

4.5

4.4

4.0

4.0

4.0

3.9

4.0

4.0

3.8

-3.7

4.5

4.0

Consumption

-6.9

-33.2

38.5

6.4

4.3

4.2

4.1

4.0

4.1

4.0

3.9

3.9

-3.9

5.5

4.0

Private Fixed Investment

-1.4

-29.2

20.7

5.7

3.9

3.9

4.0

4.0

4.0

5.4

5.4

5.5

-3.6

3.8

4.5

– Business

-6.7

-27.2

15.0

3.9

3.9

3.9

3.9

3.9

3.9

5.8

5.8

5.8

-5.3

3.0

4.5

– Residential

19.0

-35.6

47.9

13.3

4.1

4.1

4.1

4.1

4.1

4.1

4.1

4.1

3.4

7.3

4.0

Government Expenditure

1.3

2.5

3.2

-2.0

-2.5

-0.2

-0.2

-0.2

0.7

1.0

1.6

1.6

2.1

-0.5

0.5

Domestic Demand

-6.1

-30.5

32.8

5.7

4.2

3.9

4.0

3.9

3.9

3.9

4.0

3.7

-3.8

5.0

4.0

Exports

-9.5

-64.4

94.1

23.9

2.6

2.3

2.3

2.3

2.3

2.3

2.3

2.3

-10.7

8.2

2.3

Imports

-15.0

-54.1

92.4

26.2

2.4

2.4

2.4

2.4

2.4

2.4

2.4

2.4

-9.4

10.0

2.4

Labour Market

Unemployment Rate (%)

3.8

13.0

8.9

7.5

6.2

5.9

5.6

5.5

5.5

5.4

5.4

5.3

8.3

5.8

5.4

Payroll Emp. (Mth Chg 000s)

45

-6070

2359

1000

833

333

333

200

200

200

200

200

-667

425

200

Non-Farm Productivity

-0.3

10.1

11.5

-4.0

-2.6

1.2

1.3

2.3

2.3

2.3

2.4

2.2

3.3

1.1

2.1

Income & Saving

Real Personal Disp. Income

2.6

46.7

-19.5

1.1

2.5

3.8

3.3

3.2

3.5

3.6

3.6

3.7

6.0

1.9

3.5

Average Hourly Earnings (%y/y)

3.1

6.5

6.0

5.9

5.6

2.2

2.4

2.4

2.5

2.8

3.0

3.3

5.4

3.2

2.9

Saving Rate (% of Disp. Inc.)

9.6

25.6

15.0

13.9

13.5

13.4

13.2

13.1

12.9

12.9

12.8

12.8

16.0

13.3

12.8

Prices (%y/y)

Consumer Prices

2.1

0.4

1.3

1.4

1.7

3.3

2.5

2.4

2.4

2.3

2.3

2.3

1.3

2.5

2.3

Core Consumer Prices

2.2

1.3

1.7

1.8

1.9

2.9

2.3

2.2

2.2

2.2

2.2

2.2

1.8

2.3

2.2

Markets (end period)

Fed Funds Rate Target (%)

0.13

0.13

0.13

0.13

0.13

0.13

0.13

0.13

0.13

0.13

0.13

0.13

0.13

0.13

0.13

10 Year Treasury Yield (%)

0.6

0.7

0.6

0.5

0.5

0.5

0.5

0.5

0.5

0.5

0.5

0.5

0.5

0.5

0.5

Dollar/Euro

1.09

1.10

1.18

1.20

1.20

1.20

1.20

1.20

1.20

1.20

1.20

1.20

1.20

1.20

1.20

Other

Current Account (% of GDP)

-2.1

-3.5

-2.3

-2.4

-2.4

-2.4

-2.3

-2.3

-2.3

-2.3

-2.3

-2.2

-2.6

-2.3

-2.3

Federal Gov’t Bal. (% of GDP)

-16.0

-8.5

-6.0

Sources: Refinitiv, Capital Economics


Overview

Elections, vaccine, and virus resurgence all key risks

  • Following a 3.7% decline this year, we expect GDP growth to be a solid 4.5% in 2021, but the risks to that forecast on both sides are, frankly, enormous. The key downside risk is that recurring waves of coronavirus infections during the winter flu season prompt more economy-damaging lockdowns. The key upside risks are that an effective vaccine becomes widely available early next year or that, post-election, the new Congress agrees on another major fiscal stimulus.
  • As the lockdowns were lifted from May onwards, the early stages of the recovery were a little stronger than we had expected, and third-quarter GDP growth will be close to 30% annualised. (See Chart 1.) The recovery in spending outpaced the recovery in production, with retail sales now well above the pre-pandemic February level, whereas manufacturing output continues to lag behind. (See Chart 2.) The upshot is that, unusually for the early stages of a recovery, inventories look very lean. (See Chart 3.)
  • But the pace of the recovery quickly slowed; initially as the second wave of infections prompted the reintroduction of some restrictions, and more recently after key fiscal stimulus measures were allowed to expire. As a result, we forecast that fourth-quarter GDP growth will be a more muted 4.5%, with the quarterly gains then slowing gradually throughout 2021. Under that scenario, the economy would still be slightly below its pre-virus path at end-2022. (See Chart 4.)
  • In all likelihood, however, that forecast will be dramatically wrong in one direction or another. On the downside, there is a risk of recurring waves of coronavirus infections that worsen during the winter flu season. Admittedly, the US already experienced a major second wave that didn’t send the recovery into reverse, largely because the lower mortality rate meant states could avoid a return to draconian lockdowns. (See Chart 5.) But the most recent resurgence in other countries demonstrates that this will be a recurring problem and the next wave could be even more severe.
  • The possible introduction of a vaccine next year represents a significant upside risk. Admittedly, a vaccine is unlikely to be a silver bullet since its effectiveness will be well below 100% and it will take time to deploy widely. Nevertheless, it could give sentiment an immediate lift.
  • With the prospects of a pre-election fiscal stimulus having faded, our forecast doesn’t factor in any additional action next year. That is because the timing, size and composition of any new stimulus depends crucially on the outcome of November’s elections. The betting markets suggest that the Democrats will win both the White House and the Senate, raising the prospect of a large mostly deficit-financed stimulus – albeit one that includes some tax hikes. (See Chart 6.) But a bipartisan compromise is still possible if President Trump wins or the Republicans hold the Senate.
  • Finally, with the unemployment rate falling back sharply, (see Chart 7) inventories unusually lean and physical distancing restrictions boosting costs, we expect inflation to rebound more quickly than the Fed’s forecasts suggest. (See Chart 8.) Nevertheless, following its adoption of an average inflation target, we don’t expect inflation to climb high enough for the Fed to even think about thinking about raising interest rates.

Overview Charts

Chart 1: Real GDP

Chart 2: Retail Sales & Manufact. Output (Feb = 100)

Chart 3: Business Inventory-To-Sales Ratio (%)

Chart 4: Real GDP ($ Trillion)

Chart 5: COVID-19 Infections & Deaths

Chart 6: Election Betting Odds (%)

Chart 7: Unemployment Rate (%)

Chart 8: CPI Inflation (%)

Sources: Refinitiv, CE, PredictIt


Consumer Spending

Consumer recovery to lose momentum as fiscal support expires

  • The initial post-lockdown recovery in consumption was impressive. But, with the enhanced unemployment benefits expiring and ongoing physical distancing restrictions still weighing on services spending, consumption growth is already losing momentum. Nevertheless, spending should return to its pre-pandemic level by the middle of next year. We expect real consumption to rebound by 5.5% in 2021 and 4.0% in 2022. (See Chart 9.)
  • After initially plunging by more than 18% between February and April, consumption is now less than 4% below its pre-pandemic level. Goods consumption staged a particularly impressive resurgence, with spending on groceries, furniture, motor vehicles and recreational goods well above February levels. (See Chart 10.) After plunging by a record 34% annualised in the second quarter, real consumption rebounded by close to 40% annualised in the third quarter.
  • Nevertheless, the recovery from here is likely to be much more gradual. The pace of monthly consumption gains has already slowed sharply and we expect quarterly growth to slow to about 6% annualised in the fourth quarter. (See Chart 11.)
  • In part, that’s simply because the big gains in activity from the reopening of the economy have already happened. Weekly data show that, after rebounding sharply in May and early June, consumer foot traffic at retail stores has been little changed over the past three months. (See Chart 12.)
  • At the same time, consumption will continue to be held back by ongoing weakness in the services sectors most affected by physical distancing requirements and travel restrictions – like food & accommodation, recreation and transport services. (See Chart 10 again.)
  • Despite the plunge in employment, the unprecedented fiscal support means that personal incomes initially increased after the pandemic struck. (See Chart 13.) A post-election fiscal stimulus could yet provide a renewed boost to incomes next year. But in the meantime, the recent expiry of the $600 weekly unemployment insurance payments means that support is now fading, with President Trump’s executive orders designed to partially extend the benefits providing only limited support.
  • But the bigger determinant of spending will be what happens to personal saving which, despite falling back sharply in recent months, is still close to a record high. (See Chart 14.) Higher levels of precautionary saving could weigh on economic growth over the coming years, but we doubt it will remain this high indefinitely. Consumer confidence has remained well above the lows seen after the financial crisis and is now rebounding. (See Chart 15.)
  • There is also no need for households to deleverage – even leaving aside the temporary surge in disposable incomes, the ratio of household debt to assets is at its lowest in decades and, with interest rates at unprecedented lows, the costs of servicing that debt have fallen. (See Chart 16.)

Consumer Spending Charts

Chart 9: Real Consumption

Chart 10: Real Consumption (% Chg. Feb to Aug)

Chart 11: Real Consumption

Chart 12: Consumer Footfall Traffic (20th Jan=100)

Chart 13: Change in Personal Income since Feb. ($trn)

Chart 14: Personal Saving Rate (% of Disposable Income)

Chart 15: UoM Consumer Confidence Index

Chart 16: Household Debt Ratios (%)

Sources: Refinitiv, NinthDecimal, CE, BEA


Investment

Low interest rates providing a big boost

  • Low interest rates are contributing to a strong rebound in private fixed investment which, after declining by 3.4% in 2020, we expect to rebound by 4.0% in 2021. But that masks a big divergence among the different components of investment, with prospects for residential property brightest.
  • The hit to investment in the first half of the year was more modest than the decline in output, and far shallower than the drop seen during the financial crisis. In contrast to 2008/09, residential investment is leading the recovery this time around, with business and government investment set to lag behind. (See Chart 17.)
  • With record-low mortgage rates and the release of pent-up demand spurring home demand, residential investment is set to rebound back above pre-virus levels in the third quarter. Much of that reflects a jump in real estate agent fees linked to the surge in home sales. But with homebuilder confidence elevated and housing starts back at pre-pandemic levels, permanent site residential investment looks set to make a full rebound over the coming quarters too. (See Chart 18.) In a year when the overall economy will shrink by close to 4%, we expect residential investment to rise by 3.2%.
  • Intellectual property investment looks set to continue outperforming, with software investment in particular set to hold up well. (See Chart 19.) Business equipment investment has also benefitted from the shift to working from home, with a big one-off increase in IT equipment investment, which accounts for 40% of the total. (See Chart 20.) The V-shaped recovery in the monthly durable goods figures suggests that overall business equipment investment looks to have reversed much of its second-quarter decline in the third. (See Chart 21.)
  • By contrast, structures investment looks set to lag behind. While global oil prices should help push mining investment higher over the rest of this year, it will remain well short of levels seen earlier this year. (See Chart 22.) The downturn in commercial property, in particular the office and retail sectors, will be a drag for years to come.
  • Over the next few quarters, we are likely to see a huge contribution to GDP from a rebound in private inventories. After falling sharply in the second quarter, firms’ inventory levels now look incredibly lean. (See Chart 23.) That suggests firms will need to rebuild inventory over the coming quarters, with inventories switching from a big drag to a boost for GDP growth. The overall impact on GDP will be more modest, however, because a large share of those goods will be imported.
  • One legacy of the lockdown, which will leave a mark well after the virus has gone, is the sharp increase in corporate leverage, the first time that has happened during a recession. (See Chart 24.) That comes at a time when corporate debt levels were already close to a record relative to GDP.
  • With the Fed keeping a lid on interest rates, there is little immediate threat of a crisis. But those high debt levels could weigh on investment over the medium term.

Investment Charts

Chart 17: Investment (%y/y)

Chart 18: Homebuilder Sentiment & Housing Starts

Chart 19: Business Investment (% y/y)

Chart 20: Business Equipment Investment (% q/q Ann.)

Chart 21: New Orders Survey & Durable Gds Orders

Chart 22: Oil Prices & Mining Investment

Chart 23: Business Inventory-to-Sales Ratio

Chart 24: Non-Financial Corporate Debt (% y/y)

Sources: Refinitiv, Capital Economics


External Demand

Tensions with China to escalate, regardless of who wins in November

  • The strong rebound in domestic goods demand has blown out the trade deficit, but with demand overseas also now picking up and the dollar weakening, we do not think that marks the start of a sustained deterioration in the current account. While Joe Biden would bring a much less aggressive approach to trade policy, we suspect the relationship with China will continue to deteriorate, regardless of who occupies the White House.
  • After contracting more severely than during the financial crisis, both exports and imports have rebounded sharply, as global supply chains quickly resumed. (See Chart 25.)
  • The stronger-than-expected rebound in US consumer demand, especially for goods, together with the V-shaped recovery in China’s production means that the rebound in imports has been particularly rapid, pushing the trade deficit to a more than decade high. (See Chart 26.)
  • The more sluggish rebound in demand in key US export destinations helps to explain why exports have been slower to recover. (See Chart 27.) That has been compounded by weak demand in certain US export categories, notably commercial aircraft which, thanks to the 737 Max problems, had been lagging long before the pandemic, as well as travel exports. (See Chart 28.) A rebound in both remains a long way off.
  • Further ahead, the contraction in US shale output looks set to worsen the trade deficit, with oil imports set to rebound as demand gradually returns. (See Chart 29.)
  • At the margin, the trade deficit will be kept in check by a weaker currency. On a trade-weighted basis, the dollar is already at pre-pandemic levels and with US interest rates set to remain low for a long time, we expect the dollar to continue weakening gradually over the coming year or two. (See Chart 30.) Overall, we suspect that means the US current account deficit will snap back to between 2.0% and 2.5% of GDP. (See Chart 31.)
  • The pandemic-related swings in trade will eclipse any impact from tariffs or trade restrictions. Nonetheless, the election could prove a pivotal moment for trade policy, particularly when it comes to relations with the EU and allies in Asia, with President Donald Trump potentially broadening out the trade war in a second term.
  • By contrast, if Joe Biden were to win the presidency, he would seek to rebuild alliances, though his proposed “Buy American” policies and the ascendent progressive wing of the Democrat party, which is pro-protectionism, means we do not expect him to be a cheerleader for new free trade deals once in office.
  • Indeed, we suspect that even under a President Joe Biden, US-China relations will deteriorate, focused on disputes over national security and technology transfer. That reflects the growing anti-China sentiment among members of both political parties. (See Chart 32.) While Biden has criticised existing tariffs on China, we doubt he would roll them back immediately, instead attempting to build a broader coalition to pressure China into making structural changes.

External Demand Charts

Chart 25: Exports & Imports ($bn, 2012 Prices)

Chart 26: Sales & Consumer Imports (%3m/3m Ann.)

Chart 27: GDP in US Export Markets & US Exports (Q4 2019 = 100)

Chart 28: Monthly US Exports ($bn)

Chart 29: Oil Product’n & Imports (Mn Barrels Per Day)

Chart 30: Broad Trade Weighted Dollar (Jan. 06 = 100)

Chart 31: Current Account Balance (As % of GDP)

Chart 32: % Who Hold Unfavourable View of China

Sources: Refinitiv, Pew, Capital Economics


Labour

Recovery in employment will continue to lag

  • The recovery in employment is likely to continue lagging the revival in economic activity, as weakness in labour-intensive sectors like leisure and food services provides an ongoing drag. Nevertheless, we still expect the unemployment rate to continue falling, which will limit downward pressure on wage growth. (See Chart 33.)
  • The rapid initial rebound in employment has slowed in recent months, with around half of the 22 million jobs lost during March and April yet to be recovered. (See Chart 34.) With the big gains from re-opening the economy having already fed through, a continued gradual slowdown in monthly payroll growth is the most likely outcome, implying that it will take much longer for the remaining job losses to be reversed.
  • The rebound in employment looks less impressive compared to the sharper recovery in consumption, which is now only about 4% below its pre-pandemic level. (See Chart 35.)
  • The trouble is that, while employment and GDP are rebounding at a similar pace within most individual sectors, the hardest-hit industries like retail, transport and, in particular, leisure account for a much higher share of employment than they do economic activity. With those sectors likely to be weakened by on-going physical distancing requirements, the labour market is likely to remain relatively weak. (See Chart 36.)
  • The unemployment rate has fallen unusually quickly since lockdowns were lifted, dropping to 8.4% in August, from a peak of 14.7% in April.
  • That drop back mainly reflects workers who were put on temporary layoff returning to their old jobs. (See Chart 37.) With that trend still looking to have further to run, we expect the unemployment rate to drop below 8.0% by the end of this year. But the rising number of permanent job losses highlights that the hit to the labour market will not be fully reversed for some time. We forecast that the unemployment rate will still be above 5.0% by end-2022, well above the 50-year low seen before the pandemic.
  • Nevertheless, other indicators suggest that labour market slack has not increased as much as the unemployment rate implies. The net share of consumers saying that jobs are hard to find has risen by much less than it did during the last recession and is at a level normally consistent with an unemployment rate of only about 6%. (See Chart 38.) The JOLTs data tell a similar story, with the rapid rebound in the voluntary quits rate suggesting that workers are still reasonably confident of finding new jobs. (See Chart 39.)
  • This suggests that, despite the much larger initial hit to the labour market, the eventual downward pressure on wage growth will be less than that seen after the financial crisis. (See Chart 40.) Average hourly earnings growth is currently being inflated by the disproportionate loss of low-paid jobs but, once that distortion drops out, we expect annual wage growth to average 2.5%-3.0% over the next couple of years.

Labour

Chart 33: Unemployment Rate (%)

Chart 34: Non-Farm Payroll Employment (Millions)

Chart 35: Consumption & Employment (Feb ‘20=100)

Chart 36: Employment by Sector (Chg. Feb to Aug)

Chart 37: Unemployment Rate by Reason (%)

Chart 38: Unemployment & Net Jobs Hard to Get Index

Chart 39: Unemployment & Voluntary Job Quits Rates (%)

Chart 40:Voluntary Job Quits Rate & Average Hourly Earnings

Sources: Refinitiv, Capital Economics


Inflation

Balance of risks to inflation outlook lie to the upside

  • The initial impact of the pandemic was sharply deflationary, but prices have already begun to rebound and several factors unique to this recovery mean that inflation is likely to recover more quickly than in past cycles. We forecast that CPI inflation will average 2.5% in 2021, although that is partly because of base effects linked to the temporary price falls earlier this year. Inflation will drop back a little in 2022. (See Chart 41.)
  • Core CPI fell precipitously during the early stages of the pandemic, as prices plummeted in the worst-affected sectors like air fares, hotel room rates and motor vehicle insurance. More recently, however, those prices have begun to rebound, and the recovery has been compounded by inflationary effects in other sectors. (See Chart 42.)
  • As we noted earlier, with the recovery in spending outpacing the turnaround in production, inventories look unusually lean. In a normal recovery it can take up to two years for firms to work down their excess inventory, but it happened in two months in this economic cycle. The shortages are most acute with motor vehicles, where demand has been supported by very low interest rates and supply took longer to recover because of the complexities of global supply chains. But the problems are broader and have already generated a sharp rebound in core goods CPI inflation. (See Chart 43.)
  • The dollar’s recent decline will only add to the upward pressure on imported goods prices. (See Chart 44.) Up to now, the dollar’s slide has mostly just reversed the appreciation in the early stages of the pandemic, so the impact on inflation will be muted, but there is a risk it goes further.
  • The costs of complying with ongoing physical distancing requirements mean that core services inflation could also hold up better than might have been expected in an environment where the unemployment rate peaked at almost 15%. (See Chart 45.) Housing inflation has begun to fall, but the slump is smaller than we saw in the aftermath of the collapse of the housing bubble a decade ago, not least because low interest rates have also supported home sales and prices. Food services and health care inflation are actually rising, as supply is restricted and businesses like restaurants, dentists and doctors’ offices incur additional costs.
  • As well as additional non-labour costs linked to complying with physical distancing, unit labour costs spiked in the second quarter, pointing to an acceleration in core inflation. (See Chart 46.) Admittedly, that is partly a distortion that should be reversed in the third quarter, but the survey evidence is also consistent with rising core services inflation, which stands in stark contrast to what happened a decade ago coming out of the last recession. (See Chart 47.)
  • Finally, although still at muted levels, it is notable that households’ longer-term inflation expectations have rebounded this year, and the pace of that appreciation is gathering momentum. (See Chart 48.) Breakeven inflation compensation rates in the bond market are also on the up. Once again, these are unusual developments for the early stages of an economic recovery and suggest the balance of risks to our inflation outlook lie to the upside.

Inflation Charts

Chart 41: CPI Inflation (%)

Chart 42: Core CPI

Chart 43: Core CPI Inflation (%)

Chart 44: Trade-Weighted Dollar & Import Prices (%y/y)

Chart 45: PCE Selected Services Inflation (%)

Chart 46: Unit Labour Costs & Core CPI Inflation

Chart 47: CPI Services Inflation & ISM Non-Man Prices Paid Index

Chart 48: Households’ Inflation Expectations (%)

Sources: Refinitiv, CE


Monetary & Fiscal Policy

More fiscal stimulus depends on election outcome

  • With monetary policy now close to its limits, any significant new stimulus will have to come from the fiscal side. The chances of a pre-election package are now close to zero but, depending on the outcome of the upcoming elections, additional fiscal stimulus is possible next year.
  • The Fed recently adopted a flexible average inflation target and, following a sustained undershoot of the 2% target, policymakers will now seek a “moderate” overshooting for “some time”. (See Chart 49.) With the Fed’s latest median forecast showing core PCE inflation not even returning to target until the end of 2023, the fed funds rate would seem to be on hold until at least 2024, if not longer.
  • Our forecasts imply that inflation will return to target more quickly, but we don’t expect inflation to exceed 2% by enough to convince the Fed to abandon its near-zero rate policy within our forecast horizon.
  • The markets have taken the Fed’s new policy framework in stride. (See Chart 50.) Breakeven inflation compensation rates have even fallen back. Moreover, although the Fed strengthened its forward guidance, it didn’t add to its large-scale asset purchases. (See Chart 51.)
  • With the Fed’s 13(3) lending facilities proving to be a flop, resulting in its balance sheet shrinking slightly over the past couple of months, we wouldn’t be surprised if the Fed eventually expanded the pace of its large scale asset purchases from the current $120bn per month. (See Chart 52.) In particular, reserve balances held by commercial banks are back below $3,000bn, which is no higher than they were before the Fed began quantitative tightening a few years ago. If the Fed did expand its asset purchases, we would expect it to focus on buying long duration bonds, since its forward guidance is already anchoring shorter yields at close to zero.
  • Following the recent expiry of the enhanced unemployment benefits and the Paycheck Protection Program (PPP), the chances of any pre-election extension of those programs have dwindled to near-zero, particularly now that the Senate will be tied up with nomination hearings for the next Supreme Court Justice.
  • Nevertheless, there is still scope for additional stimulus next year. If the Democrats capture both the White House and the Senate, then we would expect a major largely deficit-financed stimulus, albeit one that incorporated some tax hikes. But even if Trump is re-elected, a smaller bipartisan compromise would still be possible.
  • The CBO’s analysis suggests that stimulus should focus on spending provisions, particularly assistance to state and local governments, since those provided the biggest bang for the buck in the CARES Act. (See Chart 53.) But note that all of the stimulus had relatively low multipliers of less than one, illustrating that in a pandemic lockdown, stimulus is often saved by the recipients.
  • Without more stimulus, the deficit would narrow next year (see Chart 54), although not by enough to prevent the Federal debt burden from continuing to rise. (See Chart 55.) But record low interest rates mean that, even though the debt is much higher than before the pandemic, the costs of servicing that debt are likely to remain lower for at least the next few years. (See Chart 56.)

Monetary & Fiscal Policy Charts

Chart 49: PCE Core Inflation (%)

Chart 50: Breakdown of 10-Year Treasury Yield (%)

Chart 51: Treasury Yield Curve (%)

Chart 52: Fed Balance Sheet ($bn)

Chart 53: $ Increase in GDP for Every $ Spent under CARES Act

Chart 54: Federal Budget Balance (As % of GDP)

Chart 55: Federal Debt (As % of GDP)

Chart 56: Net Interest Cost of Debt (As % of GDP)

Sources: Refinitiv, CE, CBO


Long-term Outlook

Higher public debt burden complicates the long-term outlook

  • The pandemic could change the long-term economic outlook in a number of ways, but the most obvious shift is that the higher public debt burden will necessitate even lower interest rates for longer than we previously anticipated.
  • Although the pandemic has triggered an unprecedented slump in GDP this year, which will probably be followed by an almost equally unprecedented rebound in 2021, it could have surprisingly little impact on the long-run outlook for potential economic growth. (See Chart 57.)
  • Renewed waves of infections could occur over the next year or two but, even if a vaccine isn’t developed or the population doesn’t reach herd immunity, the lesson from historical episodes is that new viruses eventually become less deadly as the population builds up its immunity. That suggests the threat will eventually recede and economic life will return to normal, even if it takes several years to reach that point.
  • Admittedly, the rapid spread of the virus around the world could lead to a permanent reduction in trade flows and migration. A simplification of global supply chains would boost US productivity levels, but at the risk of a marked increase in labour costs and, consequently, the final selling price of goods that are currently imported from developing countries. Permanently lower immigration would also put upward pressure on domestic labour costs and the resulting hit to labour force growth would lower the economy’s potential growth rate.
  • At the same time, the pandemic has accelerated some structural changes linked to technology that were already taking place – including the shift to online sales and the demise of traditional office working culture. The shift to working from home could have knock-on impacts on the value of commercial real estate, particularly in the most densely populated cities, and lead to a permanent shift toward eating at home and away from restaurant dining.
  • Overall, it is too soon to tell how all these factors will play out so, for now, we still expect GDP growth to average between 2.0% and 2.5% over the long-term.
  • We do, however, already know that the Federal debt burden will hit 100% of GDP this year, which is much sooner than we previously expected. Given the ongoing impact from the aging of the population, we expect that debt-to-GDP ratio to continue trending higher over the next couple of decades. (See Chart 58.) As long as interest rates remain unusually low, however, there is no reason to expect a debt crisis.
  • With the Fed enthusiastically going even further beyond the norms of monetary policy during the pandemic, there is little reason to expect any significant increase in interest rates for many years to come. (See Chart 59.)
  • The big question is whether the mix of high debt and very accommodative monetary policy will eventually trigger a renewed surge in inflation, as it did coming out of previous similar episodes? (See Chart 60.) As we noted earlier, although the initial impact of the pandemic was sharply deflationary, that was quickly reversed and, with inventories lean and added costs linked to complying with physical distancing requirements, inflation may bounce back more quickly than it usually does.

Long-term Outlook Charts

Chart 57: Real GDP (%y/y)

Chart 58: Federal Debt (As a % of GDP)

Chart 59: Interest Rates (%)

Chart 60: CPI Inflation (%)

Key Forecasts (% y/y Averages, unless otherwise stated)

2006-2010

2011-2015

2016-2020

2021-2025

2026-2030

2031-2050

Real GDP

0.9

2.2

1.1

3.2

2.4

2.4

Real consumption

1.1

2.3

1.4

3.6

2.2

2.4

Productivity

1.3

0.8

1.2

1.5

2.0

2.0

Employment

-0.4

1.4

-0.1

1.7

0.3

0.4

Unemployment rate (%, period average)

6.8

7.2

5.0

4.8

4.0

4.0

Wages

2.6

2.1

3.1

3.2

3.5

3.5

Inflation (%, period average)

2.2

1.7

1.8

2.3

2.0

2.0

Policy interest rate (%, end of period)

0.3

0.5

0.1

0.2

0.5

2.0

Ten-year government bond yield (%, end of period)

3.3

2.3

0.5

0.7

1.4

3.0

Federal budget balance (% of GDP, period average)

-4.9

-4.9

-6.2

-5.7

-4.5

-3.9

Net Federal debt (% of GDP, period average)

44

70

82

102

112

131

Current account (% of GDP, period average)

-4.3

-2.4

-2.1

-2.1

-2.0

-2.2

Exchange rate ($ per €, end of period)

1.34

1.09

1.20

1.20

1.20

1.25

Nominal GDP ($bn, end of period)

14,992

18,225

20,228

27,368

33,566

76,942

Population (millions, end of period)

309

321

331

343

355

390

Sources: Refinitiv, CE


Paul Ashworth, Chief US Economist, paul.ashworth@capitaleconomics.com
Andrew Hunter, Senior US Economist, andrew.hunter@capitaleconomics.com
Michael Pearce, Senior US Economist, +1 646 583 3163, michael.pearce@capitaleconomics.com