Page 7 - ISQ January 2021

JANUARY 2021

during the pandemic and people will be eager to travel, to go to A key issue for the Fed in 2021 will be deciding when and how
music and sporting events, and to resume their previous lifestyles. much to reduce monthly asset purchases. The financial markets
Most likely, the level of GDP will match the fourth quarter 2019 level (especially the stock market) have been sensitive to changes in
by the middle of 2021, but that will still leave us below trend (that the Fed’s balance sheet. As the economy recovers, the Fed should
is, without the pandemic, output would have been growing due to return focus to maintaining an adequate level of reserves in the
population growth and productivity gains). banking system.

FISCAL SUPPORT VERSUS AUSTERITY
“ Fiscal support was critical in offsetting the worst of the pandemic,
There is a trade-off between economic
but it added to the federal budget deficit, which had been trending
activity and efforts to contain the virus. at $1 trillion per year before the pandemic. The government has no
Locking things down to prevent the problem borrowing and the Fed has placed much of the increased
debt on its balance sheet. Interest rates are low and even with the
spread reduces activity. Conversely, added borrowing, interest payments on the debt over the next
opening up the economy allows the decade are projected to be lower than before the pandemic. The

virus to spread more widely. ” real danger with fiscal policy is not doing enough to support growth
and removing support too soon. Austerity may be an individual
virtue, but the government is not a household. The debt does not
need to be paid off. At some point, lawmakers should work to have
POLICYMAKER RESPONSE federal debt rising no faster than nominal GDP, keeping the debt
The worst of the pandemic was met by the best in monetary and to GDP ratio stable or declining over time; however, now is not the
fiscal policy. The Federal Reserve (Fed) quickly lowered short-term time. Tax increases or spending cuts in an economic recovery make
interest rates to near 0%, restarted lending facilities that it had that recovery weaker.
employed during the financial crisis and created some new ones As with any economic downturn, there is generally downward pres-
along the way. It also expanded the balance sheet (from $4 trillion sure on inflation, reflecting increased slack in resource markets.
to $7 trillion) to ensure that there was more than adequate liquidity Some prices fell sharply during the lockdown phase and rebounded
in the financial system. Lawmakers in Washington passed massive sharply as the economy reopened, but have since moderated. Input
fiscal support, funding healthcare, extending unemployment ben- cost pressures related to the supply chain disruptions have been
efits, offering loans and grants to small business, and aiding state noticeable, but firms generally have difficulty in passing such costs
and local governments. along to the consumer. Strong demand for durable goods added
Most Federal Reserve officials expect to keep short-term interest some pressure, but inflation in consumer services has slowed. The
rates low through 2023. The Fed revised its monetary policy goals shift to working from home has led to strong housing demand and
and strategies in 2020 and signaled that it intends to follow periods the supply of available homes for sale has been limited. However,
where inflation (as measured by the PCE Price Index) is below the high housing price inflation does not show up in the Consumer
2% target with periods of inflation above 2%. This is no mathematic Price Index. A house has two functions: it’s an asset and it provides
formula; monetary policy will remain a judgment call. However, it shelter. The Bureau of Labor Statistics seeks to measure the price
of shelter, not the asset value, and so considers the rental equiva-
does signal a greater tolerance for somewhat higher inflation. The lent – and rents have generally risen more slowly in the pandemic.
Fed’s employment goal has been made ‘broad-based and inclusive.’
Low unemployment significantly benefits low-income communi- The labor market is the widest channel for inflation pressure.
ties. The Fed will no longer tighten because unemployment falls to Average hourly earnings surged during the lockdown, but this was
a certain level. A key takeaway from the pre-pandemic years is that a byproduct of arithmetic. Job losses were concentrated in lower-
there is a lot more slack in the labor market than the official figures paying industries and in lower-paying positions within individual
would suggest. This isn’t a major change from the way the Fed has firms, which increased the average. For the private sector, the
conducted monetary policy in recent years, but writing it down was Employment Cost Index (ECI), which is not affected by compositional
an important signal for the financial markets. changes and includes benefit costs, rose 2.4% over the 12 months

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