Surveying the Economic Horizon
After months of robust recovery from anti-covid strictures, clouds have begun to gather on the economic horizon. The immediate future still looks promising. Some momentum may have come out of the powerful rebound the economy has enjoyed, but immediate prospects for growth and employment still look very good indeed, especially if, as seems likely, more people get inoculated, and the vaccines retain their efficacy. The big concerns lie on the longer-term horizon, say by the second half of 2022 and beyond. Two stand out: huge federal budget deficits and increasing inflationary pressures.
Though not all immediate indicators are upbeat, the second quarter’s 6.6 percent annual growth in the inflation-adjusted gross domestic product (GDP) was not as disappointing as some media commentary made it seem. It was instead evidence of strength. It exceeded historical averages by far, and what is more, it understated the 7.9 percent real growth in actual purchases. The difference between this stronger figure and the GDP accounting arose because business chose to meet a part of that strong demand by depleting stocks of inventories. Replenishing those stocks will boost overall growth in coming quarters.
Other indicators do, however, suggest some slowing. Retail sales for, for instance, fell 1.1 percent in July from June levels. Similarly, new home construction, always volatile, fell some 7.0 percent. If it would be irresponsible to dismiss such news, it would at the same time be foolish to extrapolate it. All these retreats come after powerful spring activity. Some retrenchment was unavoidable. Take the retail sales, for instance. Much of the overall drop reflected a singularly large 2.6 percent decline in clothing sales. In some circumstances such a loss in activity would give pause, but coming off a 3.7 percent surge the month before, the July decline hardly seems troubling. Then there was the rise in Covid infections. The first half’s drop in infections had led people to look hopefully toward a fear-free summer. But the summer rise in infections — due to greater social interactions, a slowing rate of vaccinations, and the extreme contagiousness of the Delta variant — destroyed such expectations and many spending plans along with it. Future progress on vaccinations should lift this weight.
If such news prompts concerns about the economy’s rebound, other recent evidence is universally upbeat.
The University of Michigan’s consumer confidence survey extended a strong spring with a 0.2 percent increase in July. New home sales had fallen 2.6 percent in June but recovered much of the ground lost in July, and since still historically low mortgage rates have kept new home purchasing affordable even as home prices have risen, new home construction should follow. Meanwhile, business confidence remains strong. The latest figures on new business formation have picked up smartly from a spring lull and existing business is clearly eager to spend on modernization and expansion. The GDP report for the spring quarter showed double-digit rates of growth in real spending on new equipment and technology, while the cumulative 6.5 percent annual rate of advance in new capital goods orders over the last three months all but secures future increases in such spending. Most important of all, jobs growth continues apace. The Labor Department’s most recent report showed hiring up 943,000 in July and up over 4 million over the last six months. Unemployment has dropped to 5.4 percent of the workforce, still above pre-virus levels but along with the new jobs pointing nonetheless to increasing incomes.
The balance of this evidence suggests a continued recovery over the period just ahead though at a slower pace than previously. Further out, as indicated, at least two big concerns hang over growth prospects. First on this list is the huge budget deficits created in Washington. At the moment, few are willing to criticize or even worry over deficits. The need to provide relief for the damage done by anti-virus strictures created great public support for two huge spending programs, one under President Trump and the other under President Biden. On top of this are the recent infrastructure bill and the $3.5 trillion budget reconciliation bill. Together this spending has far outstripped projections of federal revenue. Expected budget deficits by 2022 now range upwards of 18 percent of the nation’s GDP, far in excess of the historical average of 3.5-5.0 percent.
The economic problem is that the deficits will remain even as the fears and needs that have recently muted fiscal concerns fade. Once this happens, an inevitable resurgence of those concerns will prevent spending from continuing along its present growth trajectory, taking from the economy a driver to which it has by now grown accustomed. On that level alone, growth, if not facing an impediment, will lose a major lever. If, as is likely, fiscal concerns grow strong enough to induce tax increases or spending cuts or both, these will act as an immediate constraint on growth. To be sure, those arguing in favor of a less expansive fiscal stance will claim that restraint will enhance very long-term growth prospects. That point might be debatable on both theoretical and historical grounds, but whatever the truth of that very long-term reality, fiscal restraint will slow growth as it is implemented.
Inflation is still more threatening. These pressures have only become evident this year.
The consumer price index has risen at a 7.3 percent annual rate so far in 2021, way above last year’s 0.2 percent rate and the 1.5 percent average of the prior five years, 2015-19. Other price measures have followed similar patterns. So far, the authorities in Washington — Federal Reserve (Fed) Chairman Jerome Powell and Treasury Secretary Janet Yellen in particular — have dismissed the evidence of inflation, describing rapid rates of price increase as “transitory.” President Joe Biden has even gotten into the act. He told the nation a few weeks ago that the inflation was “expected” and is expected to fade soon. It is not altogether clear what the president means by “expected,” since the price surge appeared in neither his budget documents of earlier this year or in any number of Fed forecasts.
However silly the Washington authorities sound, all should nonetheless hope that they are correct and that this year’s inflation is indeed “transitory.” As anyone who lived through the great inflations of the 1970s and 1980s or anyone who has studied that time knows, inflation, once it embeds itself in the economy, has severely debilitating effects on real growth. By distorting notions of value, it makes decision making problematic, discouraging investment and denying the economy the growth support such investments otherwise give. Because stocks and bonds are denominated in dollars, inflation causes people to flee these assets in favor of real estate, gold, art, antiques, and other things that investors believe will keep up with the rising cost of living. Perhaps the recent real estate boom in part reflects this kind of thinking. And because the flight from stocks and bonds pushes up bond yields and other borrowing costs as well as driving down stock market values, it imposes an additional impediment to investment in expansion and modernization and the boost to growth those activities otherwise offer.
Inflation further clouds the longer-term outlook because it will, if it persists, elicit economically constraining policies, especially monetary policy.
Faced with inflation, the Fed will, for instance, restrain flows of money and credit as well as raise interest rates, all of which would retard economic growth, and could bring on a recession, as they have in the past. Indeed, the Fed has already started down this road. Despite Chairman Powell’s easy dismissals of inflation concerns have of late given way to a level of seriousness about the need temper the easy monetary policies of the present. The Fed has taken first steps in the direction of inflation fighting. Policy makers have wisely resisted anything radical. They have left interest rates low, no doubt because a hike would have highlighted their inflation concerns and panicked markets. What they have done is implement what are called reverse repurchase agreements to sell some of the many bonds the Fed had previously bought through its “quantitative easing” programs. Those sales have withdrawn liquidity from of the financial system and slowed the growth of the money supply. If this inflation persists, the Fed will have to go a lot further with such policies, including raising interest rates.