It’s time to ease up on the stimulus accelerator
Advance estimates of U.S. real GDP growth indicated that the economy grew at 6.5 percent (on an annualized basis) in the second quarter of 2021. This followed healthy first quarter growth of 6.3 percent. The second-quarter growth rate was below expectations primarily due to a substantial drawdown of inventories by businesses encountering significant supply constraints. Strong consumer demand and solid business investment indicate that private sector demand remains robust. While the latest coronavirus resurgence driven by the delta variant poses temporary risks, aggregate demand is expected to remain strong through the rest of the year and into next year.
Given the current economic climate, an important question for policymakers to consider is whether it is time to ease up on monetary and fiscal stimulus. There is growing concern that the current policy stance may lead to economic overheating. Additional stimulus risks tipping the U.S. into a stagflationary trap, characterized by a slowdown in growth (driven by constrained supply) and surging price levels.
Fiscal measures aimed at improving critical infrastructure and boosting the long-term productive capacity of the economy are to be welcomed. They not only offer net positive returns (in a low interest rate environment) but also tend to play out over longer-time frames and boost the stock of public capital.
However, given ongoing supply constraints, there is far less justification for measures designed to further boost short-term aggregate demand. Stimulus that mostly lifts consumer demand for goods relative to services is likely to further boost imports and worsen the already massive U.S. trade deficit. Policymakers may also be wise to retain some political capital for undertaking future stimulus if underlying conditions change dramatically.
On the monetary front, the Federal Reserve’s insistence on continuing with large-scale asset purchases or quantitative easing (QE) is increasingly hard to justify and may even be creating significant economic and financial distortions. Mervyn King, former governor of the Bank of England, recently warned that the Federal Reserve (Fed) and other major central banks risk becoming dangerously addicted to QE.
The initial rationale for QE was based on the notion that unconventional monetary measures were necessary once central banks reached the zero or effective lower bound. During a recession, if further reduction of short-term nominal policy rates is not feasible, monetary policy could still remain effective if central banks used newly created reserves to purchase long-dated government bonds and other types of assets. Such measures can lower long-term rates (mortgage rates and corporate bond yields will decline) and also encourage greater risk taking. (By reducing yields on so-called safe government bonds, the central bank incentivizes investors to seek out higher-yielding riskier assets.)
According to the NBER, the pandemic recession lasted only two months, the shortest recession on record. In 2020, given the uncertainty that existed before widespread recognition of the effectiveness of the Pfizer/BioNTech and Moderna vaccines against COVID-19, the Fed was probably justified in maintaining ultra-loose monetary conditions. But given the unprecedented levels of fiscal support currently coursing through the economy and the strong economic recovery already in progress, the Fed’s continuation of monthly asset purchases to the tune of $120 billion appears unwarranted.
Fed Governor Lael Brainard recently made the case for not rushing to taper the central bank’s QE program: “In coming meetings, we will continue to assess progress and the conditions under which it will be appropriate to start paring back the pace of our asset purchases. Twenty-four-month core PCE inflation is now running at a 2.3 percent average annualized rate. In contrast, employment is still down by 6.8 million to 9.1 million relative to its pre-COVID level and trend, respectively, and it has closed about one-fourth to one-third of its December gap. The determination of when to begin to slow asset purchases will depend importantly on the accumulation of evidence that substantial further progress on employment has been achieved.”
Gov. Brainard’s views (which are widely held among her colleagues) are somewhat perplexing. It is unclear how asset purchases will enhance job growth (especially among vulnerable segments of the population) or boost labor force participation. QE cannot fix structural mismatches in labor demand and supply or prevent changes to the natural rate of unemployment resulting from the pandemic shock. Reallocation of labor resources and early retirements will take time to play out.
The transmission mechanism associated with QE is complex. By lowering risk premia and reducing long-term borrowing costs, QE can boost private sector borrowing. The current environment, however, is characterized by limited supply of autos and new residential housing units (two sectors that are particularly interest rate sensitive) and robust demand. QE is not going to fix the computer chip shortage or boost housing inventory. But it is likely to fuel higher inflation that is particularly harmful to lower income households. On the corporate side, QE may be keeping zombie corporations alive and limiting creative destruction.
By encouraging risky investments, QE contributes to surging asset prices and a widening of the wealth gap. It is increasingly apparent that pandemic-related stimulus has contributed to the speculative excesses observed in cryptocurrencies and meme stocks.
The Fed should bring about an early end to its asset purchase programs and consider taking steps to initiate tapering of mortgage-backed securities at its upcoming September meeting. On the fiscal front, a shift in focus away from short-term demand boosting efforts and towards long-term productivity enhancing measures that improve the supply potential of the American economy is necessary.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.
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