How hot will the US economy run?

It looks likely that the US government and central bank will continue with their “running-hot” experiment for some time to come. But could the economy run too hot?

| 5 min read

The US is following a policy of running hot. The Federal Reserve led the rescue of world markets at the end of March 2020 when they were plunging due to the Covid-19 pandemic. Presidents Trump and Biden worked with Congress to pass a succession of stimulus measures. The US has produced a fiscal stimulus of around 27% of GDP so far. This was well ahead of similar measures taken by most of the other advanced countries, though Japan was also providing a large boost. The Fed produced a very large monetary stimulus at the same time. As a result, the US is forecast to have faster growth this year and to get back to the pre-pandemic starting point more quickly than most other advanced countries.

The interesting thing is that President Biden does not see the pandemic packages as sufficient or the end of the reflationary story. He has negotiated an infrastructure package with the Republicans to provide a further boost and is mulling with his fellow Democrats another monster package of $3.5 trillion in extra spending. Even allowing for the expected $23 trillion size of the US economy this year, it’s still another major increase.

Meanwhile, other advanced countries that provided fewer fiscal-stimulus measures are looking to the recovery to cut the deficits and to reduce the spending needed to support the economy during lockdowns. They want to start to long march to more orthodox levels of deficit and spending. The Fed is also one of the least prudent of the central banks, even delaying discussion of when to taper down the large amounts of new dollars they are creating to buy bonds.

Compromises likely

It is true that the possible $3.5 trillion Democrat spending plan can be adjusted down as the party has an active internal debate about how much to spend. There are a few moderate Democrat Senators and Representatives who are urging some restraint, whose votes will be important. Senator Joe Manchin is the outlier wanting a much smaller package. Bernie Sanders, the Chairman of the important Senate Budget Committee has reduced his large first demands already, as he seeks to find compromise around a high number for extra spending.

Many Democrats including the President would like to put all their wish list into the new spending package, appreciating that they could lose control of the Senate and or the House in the mid-term elections this November. They wish to get on with securing their plans before they face another electoral test.

It is also true that the Democrats wish to offset a part of the additional expenditure with tax rises. They want to raise the top rate of income tax from 37% to 39.6%, and to increase capital gains taxes on high earners. They will give more money to the Inland Revenue Service to chase tax dodgers more actively. The Tax Foundation forecasts from its economic model a 0.4% reduction in GDP from the tax rises, and some loss of jobs. The President has also asked for increases in business taxes. Some Democrats are reluctant to push corporation tax up from 21% to the 28% Mr Biden campaigned for. There is talk of a compromise of 26.5%.

Support slowly withdrawn

The Fed is still creating an extra $120bn a month for various asset purchases, which is keeping markets liquid and allows the government to fund its growing debt at relatively low interest rates. The markets expect news on tapering the monthly amount later this year, but also assume there will continue to be more monetary stimulus into 2022, which will continue to ease the task of raising the money for the deficit. The Fed has so far persuaded most in the markets that the sharp rise in inflation will prove temporary, avoiding the need for early or tough monetary action to rein it in. All the time this lasts the authorities can carry on running hot.

World supply shortages, a more hostile environment for international trade, the continuing impact of the pandemic on social activity and travel and the caution of banks and consumers about committing all their savings or more of their liquidity to spending and lending is keeping check on these very expansionary policies to some extent.

It looks as if the President, Treasury Secretary and Congress will have their way and press the “running-hot” experiment further this autumn. The outlook for US growth remains reasonable. Sceptics and critics will be watching to see how far and fast wages rise and whether views start to change about how temporary the inflation is. Once the Fed chair is confirmed for another term from early next year (or replaced) the Fed might tighten more to head off any prolonged or deeper set inflation.

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How hot will the US economy run?

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