Pandemic Relief Is an Economic Leap of Faith

(Bloomberg Opinion) -- Democrats are closing their eyes and throwing the dice. Congress is passing President Joe Biden's $1.9 trillion pandemic relief bill with shockingly little information about whether the U.S. economy can safely absorb it.

The Federal Reserve isn't helping. Its signals to markets, businesses and households have been surprisingly blasé about the possibility of the economy overheating and inflation accelerating.

Predictions are always difficult, but they are harder than ever to make now. The economy has been hit by a once-in-a-century pandemic. People have been cooped up at home for a year. Congress has already spent over $3 trillion supporting the economy. The Fed is more comfortable with rising inflation than it has been in decades. This is a moment without precedent. The standard tools of economics offer scant clarity on how another $1.9 trillion of stimulus will affect the economy.

Given how little economists understand about the probable paths of prices, output and employment over the rest of the year, policymakers should be cautious.

Let's discuss the demand side of the economy first. How will households react to the end of the pandemic? Will this summer feel like Mardi Gras?

It's easy to answer in the affirmative. But moving beyond generalities is hard. I expect lots of families to take vacations this summer, but I don't know whether a typical family will take one trip, or two. The latter implies a lot more vacation-related spending for the economy as a whole.

Or take dining out. Surely, demand for restaurant meals will soar once the vaccines are in wide distribution. But will I have four business lunches per month, or 12? Both are plausible. And if enough people are like me, the potential range of spending on business lunches is enormous.

Households are currently sitting on $1.6 trillion of excess savings due to the combination of limited spending opportunities over the past year, the surprising strength of the recovery from the spring lockdowns, and the economic support already provided to businesses and households by Congress. During the rest of the year, pandemic-related savings will grow to over $2 trillion.

How much of that will be spent over the next year or two is anyone's guess. The closest analogue may be consumer behavior following World War II, during which household savings also ballooned due to rationing and other spending restrictions. Economists at Goldman Sachs estimate that households spent 20% of their excess savings in the years following the end of the war.

Applied to today's situation, this would constitute hundreds of billions of dollars in additional economic demand. But is 20% the right estimate? Anything between 10% and 50% wouldn't surprise me.

The bottom line is that there's no rigorous way to predict how households will react to being able to resume normal life following such a difficult and unusual year. And that has big implications for the demand side of the economy.

The supply side is also uncertain. The ability of supply to keep up with demand will be hampered by the process of economic reallocation — to match consumer preferences, some industries will shrink and others will expand, requiring workers and capital to move around.

But the degree of reallocation is unknown. The common view seems to be that movie theaters won't recover. But my four-year-old son has never seen a movie in a theater, and once I'm vaccinated I would like to take him to one. It is at least plausible that a rush to normalcy this summer and fall includes people returning to theaters, to at least some degree.

Indoor dining is likely to come roaring back. But many restaurants have built up carryout capacity, and local governments have created spaces for outdoor dining. Will those shrink as indoor dining grows? Or will they remain?

There are currently around 10 million fewer jobs than there were when the pandemic began last March. How quickly those jobs return depends in part on how unemployed workers react to the $400 weekly federal supplement to standard, state-provided unemployment benefits that they will receive when Biden's stimulus passes.

The research on expanded benefit generosity from last spring and summer suggests that the $400 payments won't keep unemployed workers on the sidelines. The research from decades prior to the pandemic suggests the opposite. I am pretty confident that plenty of people will prefer to collect unemployment checks — waiting around longer than they normally would for the perfect job opportunity to come along — than to resume working. But there's more uncertainty than normal about their effects because we don't know precisely when daily life will normalize.

The extent to which demand surges and the ability of supply to keep pace will shape inflationary pressure. Both are uncertain. There's also a lot economists don't know about how inflationary pressure translates into actual inflation.

Inflation has a large psychological component, with price changes affecting the way households, businesses and markets think about the pace of future price increases, and expectations of future inflation affecting current prices.

In the 1970s, inflation was a major economic problem. In the early 1980s, Fed Chairman Paul Volcker convinced investors and consumers that the Fed would pay a high price to ensure low and stable inflation. By sticking with a policy of high interest rates — the Fed's policy rate climbed above 19% in 1981 — despite causing a recession in which unemployment eventually rose above 10%, Volcker anchored expectations about the Fed's unwillingness to tolerate inflation. For the subsequent four decades, the U.S. economy has benefited from the widespread confidence that the Fed will not tolerate high inflation, and actual inflation has been low and stable as a result. 

Today's Fed is more welcoming of higher inflation than the U.S. has recently experienced, both with its communication about current fiscal policy and its new monetary policy framework that would allow the rate of inflation to temporarily rise above the Fed's target.

Add to this the message being sent by Congress that Biden should follow his $1.9 trillion stimulus with trillions of dollars of additional spending on infrastructure, health care and measures to fight climate change, and it is reasonable to ask whether markets and individuals will continue to expect low and stable inflation. Maybe they will, maybe they won't — economists don't understand this process very well, and the economy is in very unusual circumstances.

And if inflationary pressure results in actual inflation, would that be so bad? Markets currently expect 2.4% inflation over the next five years. In my view, that pace of price increases would be a policy victory.

But markets could be underestimating how prices will respond to another $1.9 trillion in stimulus, the extent of household spending sprees, the ability of supply to keep up and the stickiness of inflation psychology.

In the face of this uncertainty, the president's stimulus is a major risk. So is the Fed's apparent indifference to the possibility of overheating. We will soon find out if those risks materialize.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Michael R. Strain is a Bloomberg Opinion columnist. He is director of economic policy studies and Arthur F. Burns Scholar in Political Economy at the American Enterprise Institute. He is the author of “The American Dream Is Not Dead: (But Populism Could Kill It).”

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