We think our forecast scenario is reasonable, especially for the next few quarters. At the same time we have a gut feeling that it is optimistic. As we have been saying for more than a year, we are in an unprecedented situation with many uncertainties. These involve different time frames and cut in different directions. Some could offset; some could be synergistic. Probabilities are impossible to calculate.
One way to think about these issues (appealing to an economist) is in terms of aggregate supply and demand. Starting with demand, the basic strategy of both fiscal and monetary policy over the past year has been to prop up demand. On the fiscal side, this mainly involved multiple large transfer payment programs that vastly enlarged household incomes – by a cumulative total (through March) of $1.7 trillion. The PPP loans/grants in large part also went to support incomes of workers who would otherwise have been laid off during the shutdown. The ultimate goal of this support was to allow households to maintain their spending – that is, to support consumer demand.
On the monetary side, the Federal Reserve quickly reduced short-term rates (almost) to zero and also instituted a large
continuing program of asset purchases designed to put downward pressure on longer-term rates. This too was intended to encourage demand – by both households and by business.
To some extent, all this effort has been successful – as evidenced by very strong sales of durable goods and the level of housing activity. This could continue, potentially at levels beyond that in our forecast. If so, restart could spill into an unsustainable boom.
But at the same time, so far, a large proportion of the added income has been saved (that is, not spent). Suppose that residual COVID concerns, or perhaps more fundamental lifestyle shifts, make households reluctant to go out, travel, return to office work. All that unspent income remains unspent. On the business side, what if business faced with continuing high uncertainty – about long-run demand for their products, regulation, taxes – is reluctant to invest in new capacity? This could mean that the restart stalls out later this year. If so, then what?
On the supply side of the economy supply chain worries are a major concern. These are clearly an actual problem, at least in the near-term. The danger is that they could persist beyond the next couple of quarters. A second supply issue is labor availability. This, too, is an actual current problem, and also one that could be persistent. Its causes are not well understood. Suspects include problems with childcare due to school closures, generous unemployment compensation, lifestyle shifts, and underlying demographic trends, among others.
Finally, there are problems that could arise from the interaction of supply and demand. Strong demand and/or supply problems would imply excess demand. In fact, this was the case in Q1 as evidenced by the rundown in inventories. If it persists it could produce at least a temporary bout of inflation. The real danger is that a “temporary” period of inflation affects expectation in a pernicious way.
Another negative interaction effect could arise in the financial markets. If there is weakness in aggregate demand or lack of supply that impedes spending, excess savings and Fed purchases will both flow into the financial markets, which by many calculations are already at high valuations.
All this said, our baseline expectation is for continuing recovery. But we do not recommend complacency.