Outlook and Market Review – First Quarter 2021

The Bureau of Economic Analysis reported that the U. S. economy grew in real terms at an annualized rate of 6.34% in the first quarter of 2021 following a 4.33% rate in the fourth quarter. The implicit price deflator used to adjust nominal GDP for inflation was 4.07%, representing robust price increases that do not normally occur in the early phases of an economic rebound. Inflation rates measured by the PCE jumped to 0.6% in the months of May and again in April with a 3.6% year-over-year inflation rate. A key policy issue will be whether inflation pressures are transitory or persistent, in which case the Fed will need to reverse its easy money policy course. Even though inflation expectations are rising in the short term, the bond market continues to price in a moderate long term inflation rate of around 2.4%.

The recovery from the self-imposed recession will be like no other in history. The economy was strong when states ordered shutdowns and it may eventually return to the pre-pandemic nirvana of low inflation with trend growth once the economy opens. A strong rebound may be supported by consumers with over a trillion in savings, pent-up demand, low interest rates, businesses eager to hire, high equity and housing values, and enormous fiscal policy support. Outside of small businesses, the economy should emerge from the downturn with far less permanent damage than from a normal recession. Tailwinds for a recovery include the lowest household debt-service burdens since 1980 and a high level of consumer sentiment.

Longer term problems may make a prolonged recovery more difficult. The aging workforce and low birth rates are long term drags on growth. Ample immigration based on merit would be an ideal solution but it is more likely that chaotic entry of lower skilled immigrants will impose relatively high costs of assimilation. In addition to a shrinking labor force, the labor force participation rate is only 61.7%. Higher taxes to support transfer programs rather than capital assets investments will also retard growth over time. A shift to dependence on large bureaucratic government programs for healthcare, education, housing, and income redistribution may promote social equity but will come at a high cost in economic performance. Finally, staggering government debt accumulation is likely to reach a tipping point where debt service poses a serious drag on growth.

Approximately 8 million jobs were lost in the recession and it will take time to return to full employment. With about 500,000 job gains each month, it will take 16 months to return to pre-COVID employment. This puts a recovery somewhere near the end of 2022. Housing and equity prices are likely to cool off as interest rates gradually rise and higher prices dampen demand. Risks to the recovery include new virus strains, serious cyber-attacks, spiraling inflation from policy missteps, and serious tension with China and Russia. Unless Saudi Arabia increases oil exports, higher energy prices are likely from higher demand in a recovery and policy moves away from fossil fuels, such as cancellation of the Keystone pipeline and oil leases in Alaska.

Second quarter growth could be as high as 10% due to increased openings. Price pressures are likely to continue with monthly price growth of about .5%. Longer term interest rates (10 year) are expected to creep closer to 2% as investors raise their expectations of longer term inflation. Unilateral passage of another government spending package with some infrastructure components is likely but the spending effects on the economy will not be felt until late in 2021 and 2022 when the economy is already well into recovery.