What a difference a year makes! A year ago, markets were in free fall as COVID-19 cases skyrocketed, and lockdowns were starting as we had no idea how long the pandemic would last and no timetable for when an effective vaccine would come to market. Fast-forward to today, and boy, have things changed:
These are all positives, and the hope is that the momentum continues and that we get back to some level of normalcy by summer.
Many forecasts expect gross domestic product (GDP) to be in the 7% to 8% range in 2021, which would make it one of the best years since 1951! Also, the forecasts are for the unemployment rate to drop to ~3.5% by 2022, which is essentially where it was pre-pandemic.
Remember, these are forecasts and not certainties, but we are due for some bounce-back given the weakness experienced in 2020.
With the Federal Reserve’s continued support of zero percent interest rates, the recent passage of the $1.9 trillion stimulus bill, and progress on the vaccine front, it seems as though we are in the clear, right? Well, yes and no.
It is important to remember that the action taken by the Federal Reserve and Congress is unprecedented and can be viewed as an experiment of sorts since nothing like this has ever been done.
During the Great Depression, there was no government intervention, which means no stimulus checks or unemployment insurance. In fact, the Great Depression was one of the main catalysts for creating Social Security in 1935. Avoiding a repeat was of utmost importance since the Great Depression lasted for nearly a decade!
While we have many reasons to be cautiously optimistic, one outstanding issue could derail the momentum we’ve experienced thus far. The irony is, this time around, the worry is not about consumer spending. It’s about whether we are overheating the economy and promoting excess risk-taking. The world is awash with liquidity and what seems to be a promise of never-ending stimulus.
Inflation
With spending of this magnitude, the grumblings are getting louder that it’s just a matter of time until inflation rears its ugly head. The thought is if the Federal Reserve and Congress are so confident on future growth, why are they hell-bent on continuing to flood markets with liquidity?
As I addressed in “The Market Rebound and Asset Price Inflation,” when liquidity is pumped into the financial system, asset price inflation can take form. Given the Federal Reserve’s recent actions, this will likely continue for a few more years.
It seems like we have been programmed to think that inflation is always a bad thing. Some inflation isn’t necessarily all that bad in certain circumstances.
While our situation has improved, the recovery has been uneven, and many are still struggling. The Federal Reserve has indicated they are willing to tolerate higher inflation to get closer to full employment.
If successful, this would lead to global economic expansion, which means the economy would be better equipped to raise interest rates to combat inflation.
While inflation does increase our cost of living, if it comes on the back of higher wages while at near full employment, it would be a positive as rising wages help the entire working population. This is where the risk lies.
If inflation spikes prior, the Fed will be caught in a quandary where they have to either let inflation run hot, which would slow down the recovery, or risk raising rates at an inopportune time, which has led to negative consequences in the past. Either outcome could derail the recovery and would likely lead to significant market volatility.
The reality is no one knows how this is going to play out. We are in uncharted territory and in a wait-and-see approach. The sooner the economy gets back to normal, the better things will be in the long run. Some are studying the impacts of stimulus checks and whether they should become a permanent fixture moving forward, but that is a topic for a different day.
Discuss your situation with a fee-only financial advisor.
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