Chetan Ahya, chief economist and head of global economics at Morgan Stanley, said most market participants and policymakers are surprised by the speed of the economic recovery. The U.S. economy will reach pre-Epidemic output levels in the current quarter, according to Big Morgan estimates.
Starting in the third quarter of 2021, Big Morgan expects U.S. GDP to exceed pre-recession levels. The last Time GDP was above pre-recession levels was in the 1990s. The time it took then was 15 quarters, while this time it took only seven quarters. In addition, Morgan expects the U.S. economy to reach 103 percent of its pre-recession level in 12 quarters (i.e., by December 2022), compared with the 27 quarters it took to reach that level in the 1990s.
Ellen Zentner, chief U.S. economist at Big Morgan, forecasts annual U.S. GDP growth of 7.3% in 2021 and 4.7% in 2022, 2 percentage points higher than the general expectation this year and 1 percentage point higher than the general expectation next year. To Zantner’s knowledge, the gap between Big Morgan’s forecast and the general expectation is the largest ever.
How did Big Morgan come to the conclusion that GDP could exceed pre-epidemic levels? It focused on a regime shift in monetary and fiscal policy, with policy makers aiming to create a high-pressure economy to deal with the far-reaching effects of external shocks.
In particular, fiscal policy has done much more than fill the output gap. Transfer payments to households have exceeded the income lost during the recession. As the U.S. gradually reopens, the labor market is poised for a significant rebound. This means that consumption growth in 2021 will depend largely on wage income and transfers rather than on excess savings.
The volume of excess savings (household savings that exceed the pre-epidemic income run rate) will still rise to a peak of $2.3 trillion in the third quarter of 2021. Even by the end of 2022, excess savings in the U.S. will only decrease modestly to $2.14 trillion (8.7% of GDP). An excessively fast downside would create upside risks to growth.
If DAMO’s forecast is correct, then a surge in demand will soon lead to a resource crunch, with the inevitable result of higher Inflation. DAMO expects inflation to remain above 2% this year and next, after a brief spike in the spring.
Such a forecast may not be of concern to the Fed, as they are now looking for a moderate rise in inflation. But what happens if inflation stays above 2% for an extended period of time while unemployment is low? Ahya worries that inflation could quickly enter an acceleration phase by the second half of 2022. The risk he sees is that inflation will not only exceed 2% slightly, but could also break 2.5%, which is the Fed’s tolerance floor.
His concerns are twofold.
The first area is the speed of labor market recovery. Although the labor market is still quite weak, the current rebound is likely to be faster than expected. Although restrictions have not been fully lifted, the overall unemployment rate has fallen from a peak of 14.8% in April to the current 6.2% in just 10 months.
Over the same period, the potential unemployment rate has fallen even faster, from 23% to 10%. In the last economic cycle, it took 72 months for the unemployment rate to fall from 10% to 5%. In the last two economic cycles, the unemployment rate has only fallen by an average of 5 basis points per month. With the full lifting of restrictions and a surge in demand, the labor market will improve much faster than it has in the recent past.
The second aspect is the uncertainty of the natural unemployment rate. Every recession leads to restructuring. The change in behavior due to the epidemic has accelerated the process even more. As a result, the natural rate of unemployment may have risen, and may be higher than normal. Inflationary pressures from rising wages may also be alarming in the context of a rapid labor market recovery.
Since the Fed’s inflation target is still far from being reached, policy makers could follow the previous guidance that monetary tightening is still not being considered. However, too rapid a pace of development could allow inflation to exceed expectations. If inflation exceeds 2.5% by mid-2022, this could cause a dramatic change in the Fed’s expectations for monetary tightening, and with it would come dramatic volatility in financial markets.
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