As reported on Business Insider:
- Get ready for inflation to come to a post-COVID world.
- Accommodative fiscal and monetary policies along with a strong V-shaped rebound are going to support price increases.
- Inflation will hit 2% by the end of 2021 and stay above 2% over the course of 2022.
- Chetan Ahya is the Chief Economist and Global Head of Economics at Morgan Stanley.
- Visit Business Insider’s homepage for more stories.
Every recession is unique. But the consensus tends to view each recession through the lens of previous ones, particularly the most recent. As the COVID-19 recession began, consensus among economists and observers was that the deep shock would result in long-term economic scarring. But these assumptions have resulted in most people underestimating the pace of the growth recovery in the US. The bias has also produced another blind spot: economists may be overlooking the potential for renewed inflation.
A recipe for inflation
Since May 2020, I have argued that this recession has unleashed forces that will drive the return of substantial inflation after a 30-year absence of upward price pressure.
First, a strong V-shaped recovery is already underway. While the second quarter of 2020 saw the deepest quarterly GDP contraction on record, 2020 will not register as the deepest recession in US history thanks to the sharp rebound from the third quarteronwards.
Moreover, as warmer weather sets in and vaccines are distributed to protect vulnerable segments of the population, the US economy will get another uplift from March onwards, especially in COVID-sensitive sectors like hospitality and travel. Our 2021 GDP growth forecast of 5.9% is a full two percentage points above consensus. We project that US GDP will achieve pre-COVID levels in early second quarter of 2021 and will also return to its pre-COVID path (in other words, where GDP would have been absent the pandemic shock) by the fourth quarter of 2021. Most others expect GDP to reach pre-COVID levels later in 2021.
Second, since the recovery is accelerating, we are less worried than consensus about longer-term scars to the private sector’s willingness to invest or take on risk. This difference is key to our expectation that inflation will return more quickly than consensus believes. COVID-19 produced a shock more akin to a natural disaster than the typical end of a business cycle. Private-sector balance sheets were in relatively good shape when the pandemic began, as was the financial system.
What’s more, policymakers have been generous in supporting households and businesses.
In the first round of the fiscal stimulus package alone, 75% of the unemployed received more than the wage income they would have earned. Personal incomes are already 3% above pre-COVID levels, and wage compensation has reached 99.7% of pre-COVID levels.
In aggregate, household net worth has increased by $5.2 trillion since 2019, and households hold $1.4 trillion of excess savings – which we estimate will rise to $2 trillion if further fiscal stimulus is passed. Consumers are holding on to excess savings not because they are risk averse but because their spending options have been limited. With these buffers, the consumer is in good shape, and we expect a sharp rebound in spending once restrictions ease.
Third, even as the COVID-19 shock recedes, COVID-19 era policies will remain in force. A second round of fiscal stimulus is being disbursed and monetary policy will also remain accommodative. Unlike the previous cycle, when the Fed had tightened monetary policy well before inflation reached 2%, they are not likely to hike preemptively at the first uptick in inflation. All in, macro policies will remain highly reflationary even as the economy makes good progress towards its pre-COVID path, setting the stage for inflation to rise.
A unique recession
The common pushback to our views is that unemployment will remain high and hold down inflation. The thinking goes that if people are out of work, the lack of demand won’t push up prices
Our bullish growth forecasts imply that unemployment will decline rapidly. Moreover, focusing on headline unemployment rates again misses the point that this recession is unique. The nature of this shock has skewed job losses heavily towards low-wage occupations, which accounted for close to 70% of job losses at the trough in this cycle. About 78% of the job losses to date are also concentrated in sectors which are COVID -sensitive and hence they should see a rebound in labor market activity as economies reopen.
Unfortunately, this divergence between output and unemployment is likely to persist, which means that headline unemployment losses will overstate the economic impacts. However, the tough circumstances that lower-income households are facing suggest that further, targeted policy support is warranted.
The use of supportive fiscal and monetary policies in an attempt to lower unemployment rates, well-intentioned as it may be, will give rise to inflation.
If unemployed workers are unable to return to their original industries as the recovery progresses, time-intensive job training and movement to new industries will be necessary. The time needed to reintegrate these displaced workers against a backdrop of robust aggregate demand will mean that labor markets may therefore tighten earlier than the headline unemployment rate would imply. In economic terms, we expect a higher natural rate of unemployment. While this dynamic did play out post the 2008 financial crisis, that recovery was far more gradual, giving businesses and the labor market ample time to adjust.
The unique nature of this recession is paving the way for a regime shift toward higher inflation. The consensus remains firmly in the disinflation camp. Just as they underestimated the disinflationary trends of the past 30 years, they risk under-appreciating the inflation threat today. We expect US core personal consumption expenditures inflation to reach 2% by end-2021 and stay above 2% from 2022 onwards. In contrast, consensus sees inflation reaching 2% later and not crossing that threshold. In fact, we see more upside than downside risk to inflation.
One upside risk is that inflation dynamics may be less stable once it rises above 2% sustainably. In other words, the overshoot could be more pronounced than the moderate variety that we project in our base case. If inflation does overshoot sharply, expectations on Federal Reserve policy will also shift in a disruptive manner, resulting in financial market volatility.
Source: Business Insider
Author: email@example.com (Chetan Ahya)
Date: 2021 01 26
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