The Big Idea
Lessons learned in economics in 2021
Stephen Stanley | December 17, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The year now winding down was certainly full of surprises from an economic perspective. Not everything that happens during hopefully a once-a-century global pandemic has general application, but there are a few things we can take away that may inform how we judge the economy going forward. There are at least five economic lessons that 2021 has taught us.
#1 The US economy is resilient
In the face of an unprecedented set of shocks, U.S. consumers and businesses proved incredibly resilient and creative. Households found ways to alter their behavior to limit public health risk while maintaining robust demand for goods and most services, and new and existing businesses went to great lengths to alter the ways that they fulfilled that demand. Entering 2021, the consensus economic view was that real GDP growth would only modestly exceed the long-term trend of 2%, even though the economy had only begun to dig out of the deep hole created in early 2020 by the lockdowns. The consensus call at this time a year ago was for real GDP growth to average 3.3% in the four quarters of 2021, which would have left the level of activity roughly even at the end of this year with the pre-pandemic reading.
For much of the prior decade, many economists had taken the economy’s sluggish growth as a sign of secular stagnation. There was a widely held though not universal view that the economy lacked dynamism and could never generate robust growth. Many believed inflation was stuck persistently below the Fed’s 2% target regardless of the policy mix.
Against these odds, the economy zoomed ahead in the second half of 2020 and all of 2021 and appears in 2022 set to grow once again at a pace previously thought highly unlikely. We have moved well beyond merely recovering lost ground from the early days of the pandemic. Growth this year argues that the US economy can grow substantially under the right circumstances. Those betting on a return to secular stagnation are, in my view, betting not on inherent shortcomings of the US economy, but on a return to the policy mix that restrained growth in the early 2010s—particularly, tax increases and an anti-growth regulation.
#2 These aren’t normal times, so think creatively.
The consensus economic forecast for 2021 a year ago was far too conservative. Economists on average looked for growth to modestly exceed trend, for the unemployment rate to slowly recede, and for inflation to remain below 2%. In sum, the prevailing view was that the economy would gradually recover, as it did in the years after the Great Financial Crisis. The trouble is that the downturn was nothing like the GFC and the underlying condition of the economy was much healthier at the end of 2020 than it was at the end of 2010.
We had seen nothing like the Covid pandemic in our lifetimes. To assume that the economy would behave just as it had in prior economic cycles, in retrospect, made little sense. The lesson here is to allow for a much wider array of possible outcomes.
As we enter 2022, economists continue to be plagued by a lack of imagination. For example, neither the FOMC nor the private sector consensus is willing to believe that the unemployment rate can drop below pre-pandemic level of 3.5% even though the jobless rate has plunged by over 50 bp in the past two months, to 4.2%, and the demand for workers remains overwhelming. We should be willing to contemplate scenarios that might have been unimaginable in more normal economic times. Could the unemployment rate drop to 3%? Could real consumer spending growth remain explosive even in the face of inflation? Could inflation settle far above 2% or even 3%? We rule out what may seem like tail-risk scenarios at our own risk.
#3 Inflation dynamics can change fast
Undoubtedly, the surge in consumer price inflation was the biggest surprise of 2021. When it began in the spring, Fed officials and most economists were convinced we were witnessing a brief pandemic-driven one-off adjustment as categories like airfares and hotel rates rebounded after being depressed by the effects of the pandemic and as a few other line items reflected specific supply-related bottlenecks, like the chip shortage in the motor vehicle sector.
As we exit 2021, inflation has surged to the highest levels in decades and has become much broader. Suddenly, we are seeing price hikes on a wide variety of goods and services. Shelter costs have begun to reflect the run-up in home prices and rental contracts. Labor-intensive industries, like restaurants and household operations, are having to raise prices to recoup surging labor costs. And all of those supply and logistical bottlenecks that were supposed to quickly dissipate are now expected by most businesses to persist for most of 2022.
Even in the face of rising labor, materials, and logistics costs, corporate America has managed to expand profit margins. This speaks to a degree of pricing power that has not been seen for decades. The FOMC and most economists trust that the inflation situation will, over the next couple of years, revert back to the pre-pandemic status, but it is worth considering whether getting the inflation genie back into the bottle will prove more difficult. The 1970s inflation took years to ferment, but once prices began to surge, the new psychology proved very difficult to dislodge.
No matter how aggressive the FOMC gets next year, monetary policy will almost surely still be substantially stimulative at the end of 2022. In fact, the dot projections imply that monetary policy will remain on the easy side of neutral for at least three more years before we even consider the effects of the swollen balance sheet. In this environment, it is at least worth considering whether higher inflation could prove more persistent and harder to bring under control than currently expected.
#4 Inflation expectations do not lead or cause inflation
The FOMC lost its lodestar on inflation when it abandoned the Phillips Curve in 2020, altering its policy framework and basically admitting that it had no model for what causes inflation. The Phillips Curve was a flawed construct to be sure, but having no structural way to project inflation is no better. Officials were left with the circular logic that inflation would stay low as long as people expected it to.
There is a certain truth to the proposition that inflation cannot take off in a sustained way unless or until households and businesses begin to embed expectations of rising prices into their behavior, changing their attitudes toward wage demands and price-setting, for example.
However, while well-anchored inflation expectations are a nice security blanket for the Fed when inflation is benign, waiting for long-term inflation expectations to zoom higher before worrying about inflation is a recipe for closing the barn door after the horse has bolted. Consumer expectations of inflation, though not directly measured back then, were clearly quite low in the 1960s. However, in the face of excessively easy fiscal and monetary policy, the economy overheated, inflation rose, and over time, people came to expect high inflation to continue.
The Fed has in the past gotten itself into a lot of trouble whenever policymakers began to ignore the pivotal role that monetary policy plays in determining inflation As Milton Friedman first said, “inflation is always and everywhere a monetary phenomenon”. All of the excuse-making by Fed officials in 2021 about bottlenecks and this or that transitory factor sounded an awful lot like Fed commentary on inflation in the 1970s, and the result, at least so far, has been similar.
There are two lessons to be learned on this point. First, neither policymakers nor market participants should rely on low inflation expectations as a guarantee that inflation will remain quiescent when policy is clearly too easy. Second, Fed officials need to work harder to come up with some sort of structural model to explain inflation better, and they would do well to make sure that it includes some sort of mechanism to incorporate the amount of liquidity that the Fed is pouring into the economy.
#5 Fiscal policy can be potent – for better or worse.
The conventional wisdom in economics appears to have come full circle over the past 50 to 60 years. During much of the post-war period, fiscal policy was viewed as a more powerful countercyclical tool than monetary policy for fine-tuning the economy. At the height of fiscal policy’s primacy in the 1960s, when Keynesians had an unchallenged hold on the prevailing consensus, the federal government raised and cut taxes and spending several times in an effort to manage the economy.
After the disastrous 1970s, the appeal of using fiscal policy actively to try to fine-tune the business cycle soured. In the 1980s and 1990s, most economists came to view fiscal policy as a clumsy tool for managing the business cycle. Congress would be too slow to respond and would be driven more by politics than economics in choosing what to do. As a result, the Fed was left to try to smooth the business cycle. As an example of the mindset in this period, Congress and President Bush actually enacted a massive tax increase in the middle of a recession in 1990 and then expected the Fed to ease aggressively to counteract the contractionary fiscal impulse.
However, beginning in the 2000s, fiscal policy slowly began to make a comeback, even as the Fed remained predominantly in charge of fine-tuning the economy. The federal government issued rebate checks several times in the 2000s as a way to boost demand when the economy flagged. Then, in 2009, the Obama Administration and Congress adopted a huge fiscal stimulus package. These efforts were generally disappointing, as economic theory would suggest and empirical evidence bears out that one-time cash payments to households are normally mostly saved rather than spent.
Fast forward to the pandemic, and the prevailing view from the 1980s and 1990s was turned on its head. The Fed’s aggressive monetary policy moves undoubtedly helped at the margin, but most of what the Fed did had limited effect. Sure, the Fed’s unprecedented interventions in March and April 2020 helped to quickly calm financial markets and promote risk-taking among investors as well as paving the way for corporations to go on a borrowing spree at ultra-cheap interest rates. However, the Fed’s furious actions did little to boost the real economy directly, as its Main Street lending facility turned out to be a bust.
In contrast, fiscal policy proved surprisingly timely and effective. Several rounds of rebate checks, while mostly saved, did bolster household balance sheets, generous and expanded unemployment benefits kept millions who were laid off during the lockdowns whole financially, and the PPP small business lending program likely prevented thousands of firms from going bankrupt.
Unfortunately, Congress took the view that if some is good, more is better. While fiscal policy played a key role in limiting the damage in the early days of the pandemic and jumpstarting the subsequent rebound, the massive $1.9 trillion Covid relief package enacted in March of this year likely played a big part in the overheating of the economy.
The final round of rebate checks, far larger than what had been distributed in 2020, was divvied out at a time when households were already sitting on trillions in extra reserves saved up in 2020, providing rocket fuel to already-surging consumer demand that outstripped the productive capacity of the economy even though, as before, only a fraction of the money was spent. The extension into September of unemployment benefits that, for many workers, amounted to more than their prior jobs had paid, likely contributed to the slow recovery in labor force participation this year and, in the process, worsened the supply-demand imbalance in the labor market. And the hundreds of billions of dollars in aid to state and local governments went mostly into coffers that were already quite full from a spectacular rebound in tax receipts. This just added to the excess of cash sloshing around in the money markets from the Fed’s interventions.
The lesson here is one that I suspect politicians of various ideological persuasions will disagree on. The good news is that, in the right circumstances, fiscal policy can be a potent tool for boosting the economy. Indeed, the bulk of the benefit from policy last year came from the fiscal side rather than the Fed. However, the old critique that fiscal fine-tuning would become politicized and that lawmakers would be tempted to overdo it in doling out money to their constituents also proved true.
In addition, the economic fallout from fiscal policy can prove complicated when the interventions are large. The Covid relief packages were intended to offer classic Keynesian demand-side boosts by putting cash in the pockets of households. However, in doing so, they did two things: first, they overdid it, creating demand that was so strong that it overwhelmed the supply side of the economy, contributing to price inflation, and second they helped to constrain the supply side of the economy, as workers were financially able to sit out from the labor market for longer, collecting unemployment benefits or rebate checks.
I expect the days of Covid relief packages are over, so the lesson learned here is not so much for 2022 but for the next economic downturn, whenever that may be. I suspect that there will be a much more robust debate than in prior downturns about the proper fiscal and monetary policy response. Fiscal policy is likely to play a larger role than before, but lawmakers will need to be careful to follow Larry Summers’ 2008 advice that fiscal stimulus should be “timely, targeted, and temporary.”