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US stimulus – four things you may not have thought about

15 March 2021

President Joe Biden’s stimulus legislation may give us more to think about than the expected boost to the US economy, the impact on inflation and the Federal Reserve’s response, says Stephen Li Jen, CEO and co-CIO of Eurizon SLJ

Following weeks of speculation, the Senate approved President Joe Biden’s stimulus legislation. We now know the size of it will be the full total of $1.9 trillion (or 9-10% of GDP), jammed in over the next year. This is of course huge.

The primary market focus is the impact on inflation and the Fed’s response. While I agree this is important, I also believe that is too narrow a perspective.

So here are four other elements to think about as you digest the news:

1. A larger current account (CA) deficit: Almost all this stimulus will be focused on aggregate demand (AD) not aggregate supply (AS); this of course means a mismatch between AD and AS. Such a mismatch will almost certainly be satisfied in part, and especially in the early stages, by imports and a bigger trade deficit and a CA deficit. Exporting countries like China and other Asian countries will likely be the biggest beneficiaries outside the US, as a big part of the fiscal stimulus leaks out of the US. The current 3% or so of CA deficit could easily surge to 5-6% of GDP, matching the high seen in the mid-2000s.

2. Services and inflation: Services account for roughly 75-80% of US GDP. A good part of these services are relatively low value-add while the rest is higher value-add, which may have been less disrupted by the pandemic. A regressive stimulus package (bigger proportionate transfers to lower income groups) ought to stimulate demand for services and the net effect should in theory be inflationary, at least temporarily. The powerful structural trends (demographics, technology, and globalisation) persist, however, and may dampen the inflationary effects over time. This debate is, as I said, valid and pertinent, but indeterminate at this point because of the great uncertainty regarding the fiscal multiplier. For what it is worth, my guess is this will only lead to a temporary spike in inflation, simply because structural forces will likely be overwhelmingly strong. Additionally, the rest of the world’s output gap is too big for the US to experience sustained inflation.

3. Treasury supply is the issue, not Fed tapering: I believe there could be a tantrum without tapering. The Fed is buying $120 billion a month but may need to double this just to keep the yield from rising. The flood of Treasury issuances to finance this fiscal deficit will be huge in size, unmet by new taxes or the automatic stabiliser. The US yield curve will likely continue to steepen even with the Fed insisting it will not taper. Fed taper was a key issue in 2013 because there was no fiscal dominance back then. The situation has substantially changed now.

4. One size fits none: Remember the argument that, in Europe, the same nominal interest rates may lead to lower real rates for the fast performers like Germany and higher real rates for the slower performers, in turn perpetuating the economic divergence within Europe? This is the one-size-fits-none argument. I see something similar on a global scale. Given the dominance of the US interest rates in global activities, higher interest rates could be appropriately high and commensurate with the growth of the US economy but may be too high for the rest of the world. US real rates will remain lower than its real GDP growth rate, while for the rest of the world, this gap will shrink. Global economic divergence, with the US and China running away from the rest of the world, may be a key theme in the quarters and years ahead.

The bottom line

I see great economic divergences around the world, very different from the aftermath of the global financial crisis in 2008. The US and China will be front runners, significantly outperforming the rest of the world, with logical consequences for USD and RMB assets. Many of the popular arguments, such as 8-10% nominal GDP growth would lead to underperforming US equities and a weaker US dollar, are not persuasive to me.

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