The S&P500 and the pan-European Stoxx600 hit new highs, ahead of the anticipated sharp recovery in the second half of 2021
In the wake of the coronavirus pandemic, US fiscal policy took unprecedent steps to support households, businesses, and state and local governments.
In March and April 2020, CARES and other three Acts were enacted, with a total cost of $2.6 trillion, whereas the US Congress approved the Coronavirus Response and Relief Supplemental Appropriations Act in December 2020 ($0.9 trillion). Finally, the American Rescue Plan Act (March 2021) is expected to increase the fiscal deficit by about $1.1 trillion in fiscal year 2021 and by $0.5 trillion in fiscal year 2022.
Αs a result, the economic contraction in 2020 was shallower-than-initially expected, with real GDP declining by 3.5%, compared to -6.6% in euro area and -9.8% in the UK. More importantly, the economic recovery is anticipated to accelerate significantly in 2021, with real GDP increasing by circa 6%.
According to estimates from the Congressional Budget Office (CBO, February 2021), considering the legislation enacted in 2020, thus excluding the “American Rescue Plan”, the gap between real GDP and potential output was expected to close by late 2024, from an output gap of circa -4.4% or $848 billion in 2020.
However, even with conservative estimates for the fiscal multiplier, thus assuming that the legislation will increase GDP by circa 60 cents for every dollar that it adds to the deficit (CBO, October 2020), the “American Rescue Plan” with a total cost of $1.6 trillion (FY2021-22), could lead to GDP surpassing its potential significantly earlier-than-expected, probably in H2:2021.
Consequently, the possible overheating of the US economy remains top of mind for investors, as it could lead to a rapid acceleration of inflation and also, eventually, to monetary policy tightening by the Federal Reserve earlier-than-expected, jeopardizing the still emerging recovery and hurting both (nominal) fixed income and equity prices.
Note that according to the Federal Reserve Bank of Minneapolis, market-based probabilities of US CPI inflation above 3% in the next five years, have increased to 30%, their highest level since 2013. Regarding actual data, headline CPI inflation accelerated to 2.6% yoy in March from 1.7% yoy in February in a large part due to base effects attributable to oil prices, with core prices growth at 1.6% yoy.
According to the minutes of the FOMC meeting in March, the Federal Reserve is set to look past the anticipated inflation spike in coming months, as it is expected to be transitory, though inflation risks have turned balanced, from negative.
The fiscal impulse is expected to be scaled down in 2022, limiting any overshoot of trend economic output in 2022 and 2023. Moreover, tax increases (“Made in America Tax Plan”) are expected to offset much of the spending increases proposed on March 31st under the “American Jobs Plan” fiscal package of $2.2 trillion, which is focused on infrastructure and green investment (also spread over ten years).