February 2021 | Mid-Quarter Update

Stimulus, Inflation, and the Road Ahead

We are pleased to forward our mid-quarter update on developments within the economy and financial markets. After a slow start in January, stocks have resumed their upward trend. Bond yields have risen but still remain very low. We believe these developments suggest that most investors are looking at the remainder of 2021 with optimism.

Our outlook for the economy remains constructive. We recognize that we are in a transition period when economic series are showing a softening trend, most notable in anemic employment numbers over the last two months. Consumer spending also remains less than robust. But we are in accord with most investors as we look forward to the second half of the year when the confining effects of the COVID pandemic will be less severe. We believe this should lead to much improved economic activity. The more comprehensive view is that last spring the U.S. economy experienced a virtual collapse, only to respond quickly to massive monetary and fiscal stimulus, thereby beginning from a very low point to a new recovery/expansion cycle that we believe can be lasting. We caution that economic activity never follows a straight line but is subject to pauses or temporary setbacks within the context of a broad recovery pattern.

Low and stable inflation is a key ingredient in the ability of the economy to sustain a long recovery/expansion cycle. Almost all cycles end with the Federal Reserve (Fed) raising interest rates to combat rising inflation, the fact of which raises a potential risk to the current recovery. For many years we have maintained a consistent position on inflation. Our view has been, and continues to be, that there are a number of secular forces that have been exerting downward force on any inflationary tendencies. Among the more important
of these are the demographic factors associated with slower economic growth, the decline in productivity, the disinflationary impact of technology, and income and wealth inequality as it affects overall demand. These elements are not likely to go away soon and should remain as long-term factors in keeping inflation contained. This does not mean, however, that cyclical bouts of inflation cannot arise from misplaced policy, either monetary or fiscal.

President Biden has put forth a very aggressive stimulus plan: the American Rescue Plan. It calls for a wide range of relief and stimulus efforts that total $1.9 trillion. This plan would come on top of some $3 trillion in relief already produced by Congress in the last year. While almost all economists agree that further relief is needed to bridge the calendar between now and a broader reopening of the economy, there is disagreement on how much is needed. Those favoring the plan point to the severity of the employment problem and the risk of lasting scars from underinvestment in job creation. They also point to less than adequate stimulus in the wake of the financial crisis and the subsequent slow recovery. On the other side, Mid-Quarter Update those who fear that the plan calls for too much aid point to estimates that the output gap, the difference between actual and potential output, is about $600 billion. They caution that injecting $1.9 trillion into the economy, at least three times the size of the gap, runs a real inflation threat. The bond market seems to be siding with these fears, at least for now, as inflation is the real enemy of fixed income investing.

Policy errors are always a possibility, especially when attempts are being made to significantly alter the direction of economic events. We present this summary of the discussion of the merits and demerits of the Biden plan because inflation is the main threat to a lengthy recovery/expansion cycle. The Fed has a longterm target of two percent inflation, but last year they made a change in policy, indicating willingness to let inflation run longer above target before acting to control it. Of course, the stated policy is always subject to change, depending on how events unfold. For now, we are assuming that in the long run the secular forces will prevail to keep inflation low, but we also accept the possibility that a bout of cyclical inflation is possible if too much stimulus is injected into the economy. There are many facets to these issues, and we will be considering them all in the months ahead.

We remain hopeful that this year and next can be strong years for economic growth, and that by 2023 the economy will have settled back into a sustainable mode of reasonable growth with contained inflation and low interest rates. This we perceive to be “normal,” and if we return to it, it should be a conducive environment for businesses.