Why the Post-Pandemic Economy Will Run Hot
As the U.S. Federal Reserve wrestles inflation lower, investors wonder increasingly if its traditional target still makes sense. Should policymakers really insist on driving inflation all the way down to 2%? Haven’t pandemic and war fundamentally altered global dynamics that drove rates ever lower? Isn't this time … different?
Set aside the cardinal investment rule to heap scorn on anyone who dares utter that last question. The forces of globalization, technology and demographics that have tamed inflation and dampened growth for much of the last four decades still look powerful. What is different, however, is the growing momentum for a substantial government spending spree on a list of priorities that now outrank taming inflation.
The Fed may need to raise its inflation targets not so much because the ineffable ‘neutral rate’ has shifted, but rather because American politicians, who otherwise agree on very little, have embarked on plans for eye-watering spending on national security, climate mitigation and social transfers. Insisting on 2% will seem both futile and recessionary.
Yes, it’s interesting politically that President Joe Biden’s proposed budget released March 9 tacks to the center with a focus on closing yawning deficits over the next decade, but neither Republicans nor Democrats will find it easy to tax as much as they want to spend.
It’s worth noting that there is neither magic nor much economic theory in the 2% target. Its origins appear to date to an off-the-cuff remark by the incoming Reserve Bank of New Zealand governor in 1988 before inflation-targeting caught on. It’s mostly about avoiding deflation without letting price expectations run rampant. Zero is too low and four seems too high, but a rising chorus of economists now suggest 3% as more appropriate to the current challenge.
To fully appreciate what has changed in the global economy, it’s important to highlight what hasn’t. The tectonic forces that have encouraged saving, tempered wages and restrained investment don’t suddenly switch direction.
Globalization has evolved, but hardly ended with world trade as a percent of GDP much closer to its 2008 peak above 60% than levels that ranged from 30–45% before the turn of the century. Tech supply chains that depend on China look vulnerable, but firms facing rising costs at home will hardly abandon their hunt for less expensive labor or supplies elsewhere.
Automation that decimated factory jobs will continue to drive wages lower as it winnows out unnecessary office functions. If you're still in doubt, here’s how Chat GPT itself helps complete this paragraph accurately and inexpensively, if not stylishly: ‘New technologies can increase productivity and efficiency, leading to lower costs of production and prices for goods and services. Additionally, technological advancements can also increase competition among firms, putting downward pressure on prices as companies strive to gain market share to understand which functions can be automated and which costs can be cut.’
Finally, the Baby Boomer generation may be leaving the workforce, but its legions have largely undersaved and don't know how long their golden years may last. These retirement accounts will get spent eventually, but they are hardly likely to suddenly tip the balance between savings and investment, triggering on their own a new wave of inflationary pressures.
While the current inflation battle looks hard, therefore, it shouldn’t be that hard to keep prices stable once the 2% target is reached all else equal. Recall, it wasn't so long ago that the struggle was to reach it from below. But that’s before accounting for what looks like a structural ambition to boost government spending on priorities that transcend monetary policy concerns.
As international tensions rise, so do the calls to boost defense spending from the Donbas to the South China Sea. The record $816 billion defense budget that Congress approved this year exceeded the Biden administration’s initial request and not even isolationist calls to stop squandering money abroad seem likely to slow this momentum. And this number could almost double and still not reach military spending as a percent of GDP the last time Washington was engaged in a Cold War.
Climate change is more contentious in Washington, but the Inflation Reduction Act spending on renewable energy is just the tip of the iceberg. There will likely be spending on property damaged by extreme weather, on infrastructure to protect against storms and floods and on care for those injured or displaced. The sums are so large and unpredictable at this stage that even the Congressional Budget Office prefers to use words rather than numbers.
Then there is the continuing fraying of the U.S. political fabric as the country turns once again to electing a president. Even if most of the promises on the campaign trail never make it into law, the math of matching revenues to spending plans rarely add up. Even if there were a viable plan to pay for expanding health benefits, restoring social security or investing in education, such good intentions rarely last long.
It’s precisely the likely failure to raise taxes that pay for all these guns and solar panels and retirement benefits that makes it easy to envision these new inflationary forces. More difficult is assessing whether such price pressures will be strong enough to overwhelm longstanding forces of secular stagnation. Even more difficult will be monitoring pressures on the Fed to keep rates low enough so the government can afford all this new debt.
What’s important for investors now is that the new normal looks hotter than the old normal, with the Fed likely forced to quietly shift its target to 3% rather than 2%. They should only keep their fingers crossed that it doesn’t slide to four.