ON JANUARY 20th Joe Biden will for the second time enter the White House during an economic crisis. On January 14th he unveiled his plan for dealing with the downturn wrought by the pandemic. Viewed from the bottom up, it is a combination of vital spending on vaccines and health care, necessary economic relief and other, more debatable handouts. Seen from the top down, it is an enormous debt-funded stimulus. Mr Biden’s plan is worth about 9% of pre-crisis GDP, nearly twice the size of President Barack Obama’s spending package in 2009. And it is big, too, relative to the likely shortfall in demand that America might expect to suffer once it puts the winter wave of covid-19 behind it, and given the stimulus already in place.
A natural question to ask, then, is whether the proposal, admittedly an opening gambit in a negotiation with Congress, might overheat the economy if implemented. The most prominent figure to warn that this may happen is Larry Summers of Harvard University. His criticisms are notable both because he was an adviser to Mr Obama and because he was hitherto perhaps the world’s foremost advocate of deficit spending. “If we get covid behind us, we will have an economy that is on fire,” he said on January 14th.
There are three main reasons to suspect overheating might be on the cards: emerging evidence that the downturn may prove temporary; generous stimulus; and the Federal Reserve’s monetary-policy strategy. Take first the evidence that today’s downturn might be more temporary hiatus than prolonged slump. The number of non-farm jobs remains 10m, or 6.3%, below its pre-pandemic peak—similar to the shortfall seen at the worst of the last crisis in 2010. Yet after the first wave of infections in 2020, unemployment fell much more rapidly than forecasters expected. If job creation were to return to the average pace achieved between June and November 2020, the pre-pandemic peak in employment would be reconquered in less than a year. It was not until midway through Mr Biden’s second vice-presidential term that such a milestone was reached last time.
Bolstering the case for a rapid rebound is the fact that economic disruption appears concentrated in certain sectors, rather than spread widely. America shed jobs, on net, in December, but only because the leisure, transport and hospitality industries were decimated by social distancing. The ratio of job openings to unemployed workers remains high and, outside of the affected sectors, wage growth has not fallen very much. The shortfall in spending is similarly concentrated. Consumer spending in the week to January 3rd was down by just 2.8% compared with a year earlier, according to Opportunity Insights, a research group. Yet retail spending on goods was 16.5% higher; it is restaurants and entertainment that are in trouble. And fiscal stimulus has more than made up the disruption to incomes in 2020. In November, the last month for which official data are available, Americans’ total after-tax income was 4.3% higher than a year earlier.
Indeed, the arithmetic of stimulus is a second reason why the economy may heat up. Before December, total fiscal stimulus in 2020 amounted to almost $3trn (about 14% of GDP in 2019), much more than the probable fall in output. Social-distancing measures meant that much of this cash piled up in bank accounts. According to Fannie Mae, a government-backed housing-finance firm, by mid-December Americans had accumulated about $1.6trn in excess savings. It is hard to know what might happen to this cash pile; economists typically assume that households are much less likely to spend wealth windfalls (such as a rise in the stockmarket) than income. But if people instead regard these excess savings as delayed income, then the cash hoard represents stimulus that has not yet gone to work, to be unleashed when the economy fully reopens.
In December President Donald Trump signed into law another $935bn of deficit spending, which extended unemployment benefits, provided more support for small businesses, and sent most Americans a cheque for $600. This ensured that lost income would continue to be replaced. Mr Biden’s proposed $1.9trn of stimulus, which includes another $1,400 in cheques, would make the total fiscal boost in 2021 roughly equal to that in 2020.
Jason Furman, another former Obama adviser, calculates that the combined impact of the December package and the Biden plan would be about $300bn per month for the nine months in 2021 for which the measures will be in effect. By comparison, the shortfall in GDP, compared with its pre-crisis trend, was only about $80bn in November. Typically, Keynesians argue that fiscal stimulus boosts the economy because of a sizeable “multiplier” effect. But the case for the stimulus to be as large as Mr Biden’s proposal “has to be that you think the multiplier in 2021 is really small”, says Mr Furman. Otherwise, it seems destined to take total spending in the economy beyond what it can produce next year, resulting in a burst of inflation.
Were the economy to show signs of such overheating, the Fed might typically be expected to raise interest rates to cool things down. Indeed, since January 6th, when the Democrats won the crucial Senate seats in Georgia that might allow them to pass a big stimulus, the ten-year Treasury yield has risen from about 0.9% to around 1.1%. The yields on inflation-linked bonds have risen roughly commensurately, suggesting that bond investors have been expecting higher real interest rates, rather than just higher inflation.
But the Fed is tripping over itself to signal that monetary policy will remain loose—a third reason to expect overheating. The time to raise interest rates is “no time soon”, said Jerome Powell, its chairman, on January 14th. He also pooh-poohed the idea that the Fed might soon taper its $120bn monthly purchases of Treasuries and mortgage-backed securities. Mr Powell says the central bank has learned the lessons of 2013, when the Fed’s hints that it might taper asset purchases sent bond markets into a tizz. Monetary policymakers still say that preserving “smooth market functioning” is one of the goals of these purchases, despite the fact that no dysfunction has been seen in bond markets since the spring.
The Fed is so willing to keep the pedal to the metal because, in contrast to the recovery from the financial crisis, it is seeking to overshoot its 2% inflation target, in order to make up for ongoing shortfalls. The strategy, announced last summer, is still being digested by investors. It is unclear whether policymakers are committed to “average inflation targeting” as an end in itself, or simply as a means to stop inflation expectations from slipping too much during the downturn, argues David Mericle of Goldman Sachs, a bank. Given that inflation expectations have risen recently, that distinction might prove important. Regardless, the Fed has been clear that it will not raise rates until inflation is “on track to moderately exceed 2% for some time”.
Those who are zealously committed to breaking the world economy out of the low-rate, low-inflation trap of the 2010s might welcome the even larger burst of inflation that the current fiscal and monetary policy mix could enable. The Fed, however, is not in that camp. Were overheating to provoke it into earlier rate rises than markets expect, the assumption of cheap money that underpins today’s sky-high asset prices and the sustainability of rocketing public debt might begin to unravel.
Such a scenario remains a tail risk. The most likely outcome is that Congress agrees on a smaller stimulus than Mr Biden has proposed, and that overheating, if it occurs, proves temporary. Beyond that, nobody really knows how fast the economy can grow without setting off inflation. Should economic policy stay in uncharted territory, though, its speed limits may be tested more frequently.