Piling It On

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by Peter Jones, CFA
Vice President of Research

Week in Review

Global equity markets were up slightly this week after the U.S. experienced its greatest one-week gain since 2011 in the previous week. Interest rates took a pause in their upward move with the 10-Year Treasury flat on the week at 2.87 percent. On Wednesday, substantial market gains were erased when the Federal Reserve minutes indicated that the Fed sees a possibility of faster rate hikes due to substantial fiscal stimulus. Economic data were mostly strong with U.S. PMIs coming in better than expected while European PMIs missed but remain at elevated levels. However, U.S. existing home sales came in much weaker than expected, declining 4.8 percent from the year ago period. The housing data has led to a debate among economists about whether lower sales are due to tight inventory levels or, much worse, if higher mortgage rates are already deterring home-buyers.

Piling It On

Twice in the last three months, Congress has passed large-scale fiscal stimulus. The first was the Tax Cuts and Jobs Act signed into law on December 22, fattening the wallets of both consumers and corporations alike. The second was the Bipartisan Budget Act of 2018 which was signed six weeks later, authorizing significant federal spending for defense, discretionary non-defense programs and hurricane relief. While we have seen many instances of tax cuts followed by spending packages, this is the first occasion since the Johnson presidency in the 1960s where stimulus was injected into a strong economy running at full employment. Additionally, both pieces of legislation increase an already large federal deficit. Historically, as the economy strengthens, Congress has responded by raising taxes and cutting spending.

Large scale fiscal stimulus is typically reserved for recessionary periods or when economic growth is stagnant. The chart below shows that there is a very strong inverse relationship between the unemployment rate and the budget deficit. As the unemployment rate falls, the deficit improves and vice versa. The dotted lines portray the likely path forward which will mark a break in this trend that has held since the late 1940s.

Source: Goldman Sachs, Federal Reserve of St. Louis

Source: Goldman Sachs, Federal Reserve of St. Louis

In theory, fiscal stimulus is inflationary. Prices rise as fiscal stimulus sparks an increase in aggregate demand and both trade and fiscal deficits widen. At the same time, unemployment is low, the dollar is more than 10 percent below its 2016 peak and commodity prices are much higher, all of which put upward pressure on inflation. When unemployment drops below its “natural” rate, employers are forced to increase wages, a weaker currency leads to greater import prices and commodities are input costs for virtually all consumer and industrial products.

In summary, all signs point to materially higher inflation, something that has been absent this business cycle. While there is little doubt that both the Tax Cuts and Jobs Act and the Bipartisan Budget Act will improve economic growth, we are also entering uncharted territory with massive fiscal packages at a time when the global economy is humming. A strong economy boosted further by fiscal stimulus may create a “boom” but also may leave the Fed no choice but to hasten the pace of Fed Funds rate hikes to combat inflationary forces, putting an end to the economic cycle. Further, with deficits projected to reach more than 5 percent of GDP next year, policymakers may not have as many bullets in the chamber to boost the economy when we eventually reach the next recession. While the above commentary may seem to paint a gloomy picture, currently tame inflation, a lack of excess and synchronized strength in global economies all suggest that there is ample runway for this expansion to continue its path forward. Nonetheless, we remain vigilant in watching for signs of a turn in the business cycle.

Takeaways for the Week

  • Fiscal stimulus deep into an economic expansion is unusual

  • The economic backdrop remains healthy, but we remain vigilant for signs of accelerating inflation