Low Rates and New Fed Framework Should Help Drive Recovery
It’s clear the U.S. economy has reached a durable bottom. The S&P 500 is up 68% from 2020 lows and GDP rebounded +33.4% in the third quarter. Leading economic indicators provide confidence that the country can weather a soft patch through this winter. Moreover, a new framework intended to guide the Federal Reserve’s decisions around raising rates should help drive better economic growth in the foreseeable future.
Last summer, the Fed introduced a new “average inflation target” regime that allows it to make up for past inflation shortfalls relative to its 2% goal. The result is a higher hurdle for the Fed to raise rates. Federal Open Market Committee (FOMC) members do not expect the initial rate hike to come until 2024, at the earliest.
Monetary policy acts with lags, so this is an important development for economic growth as well as financial markets. If the Fed can wait longer to raise rates in the face of full employment and rising inflation, the implicit outcome should be that Fed policy will now remain supportive much longer into an economic cycle than in the past.
Obviously, no two economic cycles are the same. Last year’s recession was caused by an exogenous shock – specifically COVID-19 – whereas the 2008 global financial crisis (GFC) was caused by an overheated housing market and bank leverage concerns. It took a long time to deliver the appropriate policy prescription during the GFC, resulting in deep and long-lasting scarring.
This time around, the policy response has been more effective in limiting structural damage to the economy. It’s also worth noting that household balance sheets are in much better shape, home prices are rising and the financial markets are performing well today. This should allow the current recovery to be quicker (economically speaking) as there are few pre-existing issues that need to be resolved, resulting in less of a drag on the economy.
This is particularly evident in the labor market, and one of the best real-time indicators of labor market health is job openings. In the aftermath of the GFC, it took five years for job openings to recovery to pre-recessionary levels. Today, job openings have already recovered to pre-crisis levels. This suggests a return to full employment can occur more quickly and should support a higher baseline level of economic growth in the coming years.
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This is consistent with the data from the National Federation of Independent Business (NFIB) Small Business survey on hiring plans, which has similarly recovered.
Also contributing to the country’s improved economic health is the recently passed stimulus package, which will deliver $900 billion targeted at consumers, small businesses and vaccine distribution. This spending, which is largely front-loaded, is equivalent to 4% of pre-COVID gross domestic product (GDP). This should help drive low- and middle-income spending in the beginning of 2021, while higher-income spending should come back in the latter half of the year as social distancing measures ease and discretionary spending recovers as people begin dining out and taking vacations again.
In our view, the stimulus bill is an enhancement to the already strong growth prospects of 2021. In fact, we expect to see the strongest GDP growth since 2000. This is not just a one-time bounce back from the depths of the severe slowdown in 2020 either as 2022 growth is expected to be as good as in any year since 2004.
Ultimately, unprecedented stimulus actions – monetary and fiscal – short-circuited the typical bottoming process. Policymakers rightly formulated a response that rapidly ended it and fueled an upturn in financial markets. Of course, the Fed could change its approach again in the coming years, but the new framework should help drive better economic growth.