In the classic Roadrunner skit, the Coyote buries one ACME box of dynamite beneath a pile of birdseed, strings the wires to a detonator hidden behind a rock, waits for our hero to arrive and start pecking, and then forcefully pushes down on the plunger. And, of course, nothing happens. He checks the wiring, jumps up and down on the detonator, and then jumps up and down on the dynamite pile as the roadrunner exits stage left with a cheerful “beep-beep.” Finally, as he stands there dejected, boom.
You can follow the evolution of his thought process.
“It will go off.”
“It should go off.”
“Why won’t it go off?”
“It will never go off.” followed by
“Boom”
In the aftermath of the Great Financial Crisis, it seemed we had built ourselves an inflation bomb. A huge increase in government debt, monetized by the Federal Reserve, and triggered by an economic recovery should have caused inflation to surge. But as the years went by, and the mixture of fiscal largesse, monetary enabling and tightening labor markets proved entirely inert, most economists and policy makers appear to have concluded that the inflation bomb will never go off. That being said, the aftermath of the present deep but hopefully short-lived recession will give us another opportunity to ignite the inflation bomb. It may, of course, still not go off. However, investors would still be well advised to structure their portfolios with an eye to the possibility that it could.
Both the Federal Government and the Federal Reserve have gone to extremes in trying to defend the U.S. economy from the effects of the social distancing recession. Whatever the past missteps of both institutions in providing a healthy economy with excessive monetary and fiscal stimulus, it is hard to argue with the need for swift and bold action in reaction to this unprecedented crisis. However, it is important to consider how these actions will alter the investment landscape in the wake of the pandemic.
On the Federal Government side, last week Congress approved a further $484 billion package to supplement the CARES Act. All told, the federal government has now enacted four separate pieces of legislation to address the pandemic. The Congressional Budget Office estimates that these will add $2.7 trillion to the federal debt over the next 18 months. It should also be noted that the small business grant program, enhancements to unemployment benefits and aid to state and local governments, appear designed to support the economy only until the middle of this summer. If, as seems likely, large parts of the U.S. economy remain shut until the distribution of a vaccine, hopefully by the second quarter of next year, then the federal government could easily approve a further $1 trillion in aid.
This, combined with interest costs and the automatic impact of a deep recession on both revenues and spending, could result in deficits of an astonishing $3.8 trillion this fiscal year and $2.9 trillion next fiscal year, boosting the debt from 79% of GDP at the end of the last fiscal year to 109% of GDP by the end of fiscal 2021, thus eclipsing the all-time record of 108% of GDP set in 1946 as the U.S. added up the extraordinary costs of fighting World War II.
Borrowing at this pace, particularly when other governments around the world are also running fast-rising deficits, might be expected to result in higher interest rates, even in a deep recession. However, this risk has been averted, for now, by an extremely aggressive Federal Reserve.
Starting with a terse statement at the end of February, in which Jay Powell committed the Fed to use its “…tools and act as appropriate to support the economy,” the Fed has engaged in monetary stimulus unprecedented in both its scope and its magnitude.
• First, in two quick steps in early March, the Fed cut the federal funds rate from a range of 1.50-1.75% to its effective lower bound of 0-0.25%. They also eliminated reserve requirements and cut the discount rate by more than the federal funds rate to encourage banks to borrow from the discount window.