Heat Upon Re-entry: Upgrading the Economic Outlook

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Entering the pandemic was a bit like entering a wormhole, where time and space shifted as we know it. Millions were forced out of work or to work from home to stem the threat of contagion. Societal guardrails that govern behavior fell away, conspiracy theories flourished and trust in our institutions and each other eroded.

As schools moved from in-person to online learning, major gaps in support for working parents (mostly mothers) were exposed. Barriers to work emerged as day care centers closed and grandparents who once watched kids couldn’t, given the fear of contagion. Retirements by older baby boomers with a high school degree or less surged. Workers disappeared from the labor force entirely.

Fear of contagion and badgering from customers who take out their frustrations on the very workers who were deemed essential compounded. Videos of customers abusing frontline workers continue to go viral.

Employers hoping to lure back workers will have to assure their safety. Much as they did during the height of contagion, they may be forced to offer hazard pay to compensate workers for the risks of interfacing with a more belligerent public.

Between 10% and 30% of COVID survivors have suffered long-haul COVID. That translates to between 3.2 and 9.9 million people, given our current statistics on COVID cases. Many are struggling to get through the day, let alone work. Vaccines seem to offer some relief but uptake has slowed.

Supplements to unemployment insurance (UI) have further complicated decisions to return. Recent research by the Federal Reserve Bank of San Francisco suggests that “the disincentive effects of enhanced UI generosity on job search only affects a small fraction” of workers, but is “noticeable.”

The point may soon be moot. Half of all states are rolling back supplements in June, three months early. States are also looking at ways to convert funds for supplements into bonuses for those who accept jobs. That could alleviate the need for hazard pay. Small businesses could use a leg up relative to larger employers.

Competition for talent intensified as demand for highly educated workers accelerated. Firms that once agreed not to steal each others’ workers (which undermines worker bargaining power) have taken their gloves off. This has pushed up wages for new recruits but made existing employees, who are less tethered to employers in a virtual work environment, more susceptible to poaching.

Unprecedented fiscal and monetary stimulus stoked demand while the outlets for that demand remained limited. We shifted our spending from services to goods, which caught producers flat-footed and scrambling to overcome bottlenecks in the supply chain. Goods prices, which decelerated for much of the last four decades, reversed course and rose.

Now, surge pricing is kicking in as we attempt to re-enter the earth’s atmosphere. Airline fares, hotel room rates and rental car prices are all soaring.

“Real GDP growth is poised to surge at the fastest pace in nearly 70 years.”
Consumer sentiment tanked in May. Those citing concerns about rising prices hit a new record. Attitudes about buying big-ticket items like vehicles and homes, which posted some of the steepest price hikes, suffered the largest blow.

This edition of Economic Currents takes a closer look at the economic rebound and how the frictions surrounding re-entry are likely to affect the outlook. Inflation has already flared more than many expected; concerns have intensified that those gains could be sustained.

It seems it was easier to leave the earth’s atmosphere than to re-enter it. That should not be surprising given how long we have been away. The shifts will challenge central bankers who hoped to wait out the rebound in employment before raising rates. Cracks in consensus have emerged at the Federal Reserve as well. Businesses’ complaints of worker shortages and the need to pass on wage gains to prices could test their patience regarding asset purchases and the trajectory for rate hikes.

Chart 1

Real GDP exceeds Pre-Pandemic Trend

Bursting at the Seams The 2021-22 Outlook Chart 1 shows the trajectory for overall economic growth between now and 2022. The recent round of fiscal stimulus did more than fill the hole left by COVID and is expected to push the economy above its precrisis trend in 2021. That is something we have been unable to achieve since the 1980s. Real GDP growth is poised to surge at the fastest pace in nearly 70 years. During the second quarter we will easily sail past the previous peak hit prior to the crisis.

Employment tends to lag overall economic gains; it is not expected to cross the peak we hit in February 2020 until well into 2022. That is much faster than we saw in the wake of the 2008-09 recession, but that is a low bar. The recovery from the 2008-09 recession was painfully slow.

Consumers Spend to See and be Seen Consumer spending is expected to slow after surging at a double-digit pace in the second quarter. It will remain well above the pre-pandemic pace into 2022. Enhanced child tax credits, which will be paid out monthly starting in July, persistently solid gains in employment and a draining of the $2 trillion in excess savings amassed during the crisis are expected to support those gains.

Consumers are expected to pivot from spending on essentials, vehicles and big-ticket items for the home to spending on discretionary goods and services. Waiting lists at doctor and dental offices grew as people attempted to catch up on routine exams delayed by the pandemic. Visits to salons, spas and gyms picked up along with dining out.

Leisure travel is rebounding, leading to spending on luggage and clothing to fill those bags. Las Vegas hotels, which offered discounts to pandemic-fatigued travelers, were fully booked for Memorial Day weekend.

Home Buying and Building Slow Housing market activity is expected to slow. A pickup in listings by older homeowners, who held their homes off the market for fear of contagion earlier in the pandemic, will alleviate but not eliminate supply shortages. Builder backlogs stretch into 2022. Labor and material shortages have prompted many builders to hold off finishing projects they started earlier this year.

Those shifts and an increase in investors flipping homes to rent instead of sell have priced many first-time buyers out of the market. The prospect of workers returning to offices and schools reopening have alleviated the urgency to buy.

Investment Moderates, Inventories Rebuild Leapfrog investments in new technologies coupled with persistently weak commercial real estate construction are expected to place a drag on business investment in the second half of the year and into 2022. The outliers will be spending on heavy machinery and warehousing.

Producers need to ramp up and retool to rebuild inventories that were severely depleted by the crisis. The jury is still out on whether we will see a permanent shift from just-in-time to just-in-case inventory systems. For now, producers would rather be safe than sorry.

Government Spending Stalls Government spending is expected to stall in the second half of 2021 and in 2022 as stimulus comes to an end. Our forecast does not include an infrastructure package or spending for new social programs given the pushback even from moderates in the president’s own party.

Taxes could rise but not as rapidly as many feared. The administration has already scaled back its ask. Separately, the deal brokered to create a 15% minimum corporate tax rate across the Group of 7 countries (Canada, France, Germany, Italy, Japan, the U.K. and the U.S.) still requires a U.S. Senate vote to be ratified.

The administration is hoping to hire up at the IRS to stem tax evasion by wealthy households. The tax gap, taxes owed but uncollected, have swelled to $1 trillion per year over the last decade. Yes, you read that right: We lose $1T a year to tax evasion. That would go a long way toward narrowing federal budget deficits.

The Trade Deficit Narrows Exports are expected to pick up and imports to slow as economies abroad reopen. Persistently weak foreign travel means that imports of services will remain subdued. The U.S. government is weighing vaccine passports for anyone coming into the country. That could slow the rebound in foreign tourism, especially from Latin America. Miami was offering vaccines at the airport to attract foreign tourists.

Deaths due to COVID are now exceeding those in 2020 as health systems abroad are overwhelmed. Developing economies have been particularly hard hit in recent months. India, which produced but exported its vaccines, is the most devastating example of what happens when the virus is allowed to spread and mutate.

Chart 2

Inflation Flares

Risks. The largest risk to the overall outlook remains the virus and whether variants can be tamed with vaccines. That requires a wider distribution of vaccines and more people who have access to get vaccinated. Uptake in the U.S. has stalled in recent weeks as myths surrounding the vaccine remain pervasive.

Those risks are in addition to the intensifying risks associated with climate change and a jump in extreme weather events. The deep freeze, loss in power and disruptions to energy markets in February is one example.

Inflation Flares Chart 2 shows the surge in inflation associated with re-entry. The personal consumption expenditures (PCE) index is expected to peak in the current quarter. The core (excluding food and energy) PCE, which provides a better measure of underlying inflation pressures, is expected to remain elevated somewhat longer. Core PCE is expected to reach the fastest pace in three decades.

The shift in spending from goods to services, a replenishing of inventories and a return of workers to the labor force after schools reopen in the Fall are all reasons to be hopeful that the flare in inflation is transitory. Year-on-year comparisons, which boosted measures of inflation this Spring, is another reason to be optimistic that inflation will decelerate as we get into 2022.

Risks. The risk is that a vicious cycle of rising inflation and wages takes root, even as growth slows in 2022.

Fed Patience is Tested The Federal Reserve has pledged to be patient and wait for labor markets to recover more before curbing their purchases of Treasury bonds and mortgage-backed securities. Officials pledged to wait longer to raise rates.

That is easier said than done, when wages and prices are picking up rapidly. A split within the ranks of the Fed has emerged. Debate over when to curb the Fed’s monthly asset purchases has already intensified. The Fed is expected to begin tapering at the turn of the year.

We are expecting the Fed to delay raising rates until mid-2023. That is a full year sooner than many within the Fed believed earlier this year.

“The shift in spending from goods to services, a replenishing of inventories and a return of workers to the labor force after schools reopen in the Fall are all reasons to be hopeful that the flare in inflation is transitory.”
Risks. More persistent inflation would prompt the Fed to curb the support it is providing for the economy sooner and risk derailing a full recovery in employment.

Treasury Bonds Edge Higher The yield on the 10-year Treasury bond is expected to move up in the second half of 2021 and into 2022. The big move in rates is expected to be delayed until the Fed starts to raise short-term rates in 2023. Even then, rates are expected to remain low relative to history. The willingness to hold Treasury bonds has been remarkable, given the debt we have amassed.

Risks. A more persistent rise in inflation, backed by more aggressive government spending, could push government bond yields up more rapidly than expected. Those shifts could undermine financial markets, which have benefitted the most from the multi-decade deceleration in inflation and interest rates.

Bottom Line We are now on course for the strongest growth in several generations. The rush by consumers to catch up on a lost year is forcing businesses to reopen faster than they can find workers. That is creating friction and heat upon re-entry. Small businesses will need more heat protection than larger companies before parachutes open. It will take until 2022 until we hit the cooler waters of splashdown.

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