U.S. Policy Lessons from the COVID Shock
The US policy response during COVID has been unprecedented in terms of scale and speed. Of course, the pandemic is ongoing and it is early to draw firm conclusions. But we think some policy lessons can already be drawn.
This Global Macro Views flags lessons that are already clear versus where the jury is still out. First, the large scale of fiscal stimulus returned the economy to its pre-COVID trend, something that was never achieved after the 2008 crisis.
Second, measures of slack like the employment-to-population ratio, which became popular after the Great Recession because they capture changes in participation, may now overstate slack. That is because stimulus checks weakened the link between still depressed employment and very strong consumer spending.
Third, we funded large fiscal deficits via Fed QE and affiliated balance sheets, which include money market funds and depository institutions. This means that debt held beyond these entities barely rose. Markets accepted this de facto monetization, given low yields and strong Dollar.
Fourth, beneath the surface, we see worrying signs for the Treasury market. Foreign inflows, which kept long-term yields low starting with the Greenspan-era “conundrum,” were weak pre-COVID and turned negative in 2020, sparking the sell-off in March.
It took $1.5 tn in emergency QE to stabilize the market, non-trivial by any measure. We see weak foreign inflows as a secular change, making March 2020 far more than just a “plumbing” issue. Finally, the jury is still out on two of the biggest questions: (i) was stimulus too big, i.e. will there be overheating; and (ii) can we monetize debt without medium-term consequences?
PRIVATE CONSUMPTION IS BACK
Private consumption is back to its pre-COVID trend in real terms (Exhibit 1), something that was never accomplished in the wake of the global financial crisis. The US stands out among advanced economies in this regard, with only New Zealand showing a faster rebound and the median consumption level in the G10 still below end-2019 levels.
The strength of the US rebound in consumer spending means that standard measures of slack, like the employment-to-population ratio, may now overstate slack, given that stimulus checks weakened the link between employment, which remains depressed, and spending, which is strong (Exhibit 2).
Aggressive fiscal stimulus was funded largely via Fed QE and affiliated balance sheets, notably money market funds and depository banks (Exhibit 3), so that debt held beyond these entities barely rose (Exhibit 4).
COVID debt issuance was essentially fully monetized, something that markets – given low Treasury yields and strong Dollar – seem to have accepted.
TREASURY MARKET
Beneath the surface, there are worrying signs for the Treasury market. Foreign inflows, which have been important in holding longer-term yields down going back to the Greenspan-era “conundrum,” were on a weakening trend before COVID and turned negative in 2020 (Exhibit 5).
These outflows sparked the unwind of the basis trade, costing the Fed $1.5 tn in emergency QE in just seven weeks in March and April. Weak foreign inflows raise the risk of another outflow episode, a secular change for the Treasury market, where we see developments as going far beyond the widespread “plumbing” narrative.
The jury is still out on the two most important questions: (i) was fiscal stimulus too big and will the US see a material rise in inflation; and (ii) are there medium-term consequences to COVID debt monetization?