March Economic Commentary: Emerging Recovery Wary of Inflation

Image

The first signs of the long-awaited re-opening of the U.S. economy have started to appear. Recent reports portray an economy that is responding to increased vaccination distribution and the impact of the $900 billion stimulus package that was passed in late December. At the same time, growth and inflation expectations have risen significantly since the beginning of the year, resulting in increased volatility in financial markets. The additional $1.9 trillion stimulus bill scheduled to be passed this week is expected to provide further fuel for the nascent recovery.

Retail Sales
The first indication of renewed economic vitality came with the report of January retail sales, which posted the strongest growth in seven months. Sales showed strength in most all categories but were strongest in discretionary sectors. Importantly, this suggests that consumers were willing to spend some of their inflated savings, which have grown to be more than twice the levels seen pre-COVID. Consumer balance sheets are generally in better shape than a year ago as about one-third of the government payments in 2020 went to pay down debt, and another third was saved.

Personal income in January recorded the second-largest monthly increase in history (+10.0%). Analysis shows that most of that increase came from government transfer payments, which account for a far greater share of income than is normal. This dependence on transfer payments will have to change before the economic recovery can be considered self-sustaining.

Manufacturing continues to be a bright spot of the economy as production is still catching up with the more rapid recovery in spending. Customer inventories are at their lowest levels since 2009 according to the recent ISM manufacturing survey. This suggests a continued ramp-up in production as the re-opening of the economy continues.

Inflation
Besides the ongoing risks associated with COVID, one of the biggest risks on the economic horizon is the reacceleration of inflation. Inflation measures have been relatively stable the past few months. Expect to see higher year-over-year inflation numbers this spring when we start comparing to last spring’s weak numbers. Additionally, inflation expectations for the next five years are now at the highest level since 2011. Reflecting the increase in inflation expectations, bond yields have jumped recently. The 10-year Treasury bond yield has increased from 0.55% last August to 1.58% last Friday. The new stimulus coming this week will likely push expectations and rates even higher over the next few quarters.

The current concerns about increased inflationary pressures are not likely to be long-term, however. The excessive debt that has been created globally to provide support during the pandemic is deflationary, not inflationary.

Employment
The February employment report was the most recent confirmation of the emerging recovery. Non-farm payrolls improved by a surprising 379,000 despite the challenging weather in February. Significantly, 355,000 of the gain came in leisure and hospitality payrolls – industries that were most impacted by COVID. The improving vaccination process is enabling these service sectors to re-open.

Although the employment report was generally viewed positively, the Federal Reserve reminds us that employment is still a long way from its pre-COVID levels – and consequently they are committed to maintaining an accommodative monetary policy with low interest rates. We are still 9.5 million jobs below February 2020 levels. It should be remembered that during the 2008-2009 recession, the worst decline in jobs from peak to trough was 8.7 million – we’re beyond that. The most recent report on persons claiming unemployment insurance is 18 million – that’s about nine times what was normal pre-COVID.

Finally, attention to the virus is still warranted as numbers of infections appear to be plateauing around 70,000 new cases per day. Although that is significantly down from the peak of 250,000, it needs to go lower for the re-opening of the economy to maintain its growing momentum. Once COVID has receded further, the historic amount of fiscal support that is coming from the government suggests that the expected 5% growth rate of real GDP in 2021 may be on the low side.