By Chetan Ahya, global head of economics at Morgan Stanley
Mind the Gap
The extraordinary policy response to the exogenous COVID-19 shock is one of the key reasons why we expect a V-shaped recovery and a return of inflation in this cycle. But that is not all. This policy response will also bring about a remarkable shift in the trend in the US saving-investment gap (or the current account deficit), widening beyond the stable range of 2-3% of GDP that it has been in over the past nine years. The US policy response and its transmission to the rest of the world via the current account deficit plays an important role in global reflation and supports our call for a synchronous recovery in 2021.
The large, ongoing fiscal expansion has led to a further decline in US public saving. The nature of the shock and the underlying income inequality issues have prompted policy-makers to opt for a policy response that is tilted towards transfers to households and measures to boost consumption. To contextualize how large these transfers were from the CARES Act, a University of Chicago study found that 76% of workers received more from claiming unemployment insurance than they would have gotten in wage compensation, with the median worker receiving at least 45% more.
Aided by both the faster reopening of the economy and the unprecedented fiscal stimulus, consumer demand has rebounded sharply, with personal consumption expenditures expected to climb to 97.5% of pre-COVID-19 levels in September. With this V-shaped recovery, we expect a very different inflation outcome in this cycle too, which we peg as core PCE inflation moving through 2%Y on a sustained basis starting in 2022.
In the last cycle, the Fed started to tighten monetary policy well before inflation rose to 2%Y and kept tightening even though inflation had not sustainably reached 2%Y. But this time around, the Fed has already telegraphed its shift to an average inflation targeting framework. As it aims for an overshoot of inflation, we are getting greater assurance that monetary policy will remain accommodative for some time.
How will these policy responses shape the outlook for the saving and investment trends? Typically following recessions, public saving will decline but private saving rises as an offset, given the inherent uncertainty at the start of a downturn. The consensus view is that the deleveraging pressures will be intense in this cycle and hence we will most likely see a repeat of the post-2008 experience in which private saving will remain elevated for some time.
But we view things differently. We have consistently argued that the state of the private sector balance sheets were healthier coming into the recession. Private debt/GDP levels had remained stable for some time and US households had completed their deleveraging cycle. A Fed that is committed to its average inflation goal will keep real rates lower for longer too in this cycle, which will provide greater incentives for the private sector to dis-save. We think that the trend of broad-based declines in saving has been set in motion, but how far it will go depends on how expansionary fiscal policy will be.
Additional fiscal stimulus post the elections, which our US public policy analyst highlighted in last week’s Sunday Start, is a possibility in three of the four post-election party configurations. COVID-19 has exacerbated the pre-existing income inequality trends in the US. Policy-makers will continue to focus their efforts on helping low-income households, suggesting that they will err on the side of running expansionary fiscal policy for longer.
If more fiscal stimulus arrives, it will impart upside risks to the growth and inflation outlook and consequently lead to a further and more rapid widening in the current account deficit, particularly if the fiscal policy mix remains tilted towards transfers to households.
The widening current account deficit will be another factor in driving USD weaker, as our global macro strategy team forecasts. We believe that this set-up of continued low real rates and a widening current account deficit in the US will act as a reflationary impulse for the rest of the world, especially EMs, setting the global economy on a path towards a synchronous recovery in 2021.