Policy overshoot risks are increasing

Article published by AGEFI Hebdo on 10 February 2022
By Michala MARCUSSEN, Group Chief Economist

Headline grabbing inflation data, with the latest readings showing 7% in the US and 5.1% in the euro area on a year-on-year basis, have triggered a lively debate on the causes and how long these will last, be it supply chain frictions, energy prices or pandemic driven demand patterns. One cause, however, is to our minds getting less attention that it deserves, namely US fiscal policy.

When the pandemic first struck, governments around the world rightly sought to protect both households and businesses from its devastating effects. In the euro area, this allowed household incomes on average to remain near flat over the course of the pandemic, albeit with some dispersion across member states. Across the Atlantic, on the other hand, incomes soared under the successive waves of stimulus checks, triggering a substantial pick-up in demand and not least for goods.

A breakdown of inflation into Covid-sensitive and Covid-insensitive contributions, produced by the Federal Reserve Bank of San Francisco, estimates that around 80% of the gain in core inflation (excluding food and energy prices) can be attributed to the Covid sensitive contribution. Breaking this down further, the Federal Reserve Bank of San Francisco, show that around 1.6pp was attributable to demand-sensitive while 0.2pp was demand supply-sensitive, leaving 2.1pp ambiguous.

Given the key role of the US consumer for the global economy, it seems likely, moreover, that there has been some spillover effect to prices globally from the US fiscal policy response. Nonetheless, the difference between the fiscal policy response in the US and the euro area no doubt goes a long way to explaining the very different tone coming from the respective central banks. Indeed, while the Federal Reserve has indicated three 25bp rate hike in 2022 and left the door quite open to more if needed, the European Central Bank has only just set the door slightly ajar to a potential rate hike this year.

A further sharp contrast in the policy response is found on labour markets; while the approach in the euro area was primarily to keep employees protected in their jobs, the US saw unemployment spike up from 3.5% pre-pandemic to 14.7% at its peak. While the unemployment rate is now again below 4%, the participation rate has yet to fully recover and remains 1.5pp below pre-pandemic levels. It comes as no surprise that layoffs and re-hiring on this scale comes with tremendous frictions, something that is also visible in nominal wage trends across the Atlantic.

As the Federal Reserve prepares to launch its rate hike cycle at the 15-16 March FOMC, it is worth keeping in mind that the underlying dynamics of the US economy are already softening. Moreover, fiscal policy has been tightening already for some time. Looking at the fiscal impact measure produced by the Hutchins Centre, we note that this metric has been in negative territory since the spring 2021. Looking at the moving average, arguably the more economically relevant measure, this turns negative only in 2022. Normalisation of the service sector will likely offer some offset to this headwind, but we are concerned this will be insufficient not least given that many US households will as of May have to start repaying student loans that have been under moratorium as part of the pandemic related measures. The counter to our arguments of still large pent-up savings comes with the caveat that these tend to be concentrated on higher income households with lower marginal propensities to consume.

Our concern is that the Federal Reserve will be tightening monetary policy at a time when fiscal policy is already tightening quite substantially. Judging by the flatness of the US yield curve, this concern may well be shared by the markets.