“Normal” recessions permanently damage the economy. Investment suffers, leaving the economy with less capital than it might have had with no downturn. While unemployed, workers lose skills and hence productivity. Spending on R&D, a key driver of innovation, falls off as businesses focus on their current balance sheets.
But this time may well be different. In fact, some forecasters, such as the IMF, have already assumed that US GDP is likely to actually rise above the level expected before the pandemic, at least temporarily. Our new Deloitte US forecast also assumes that the economy in 2022 will outperform our prepandemic assumption. But we’re even more optimistic: It’s beginning to look as though we’ve not only avoided the “scarring” that many economists feared at the beginning of the pandemic—we’ve also accelerated technological change, meaning that productivity growth, and GDP, are likely to remain above prepandemic levels.
How does it happen that, after suffering a steep decline in production and income, a historic jump in the unemployment rate, and the trauma of a completely different type of shock that required substantial changes in behavior, the American economy might actually return even stronger?
Some reasons why the economy is poised for strong growth:
1. Business finances are healthy. Most recessions in the past had financial causes,1 and businesses (especially financial businesses) had to take time to rebuild their balance sheets. That left many business leaders leery of taking on debt or making risky investments. As a result, investment spending remained muted, people remained unemployed for a long time, and growth was limited. The current recession, by contrast, was met with firm government action that bolstered the financial system and most businesses’ balance sheets. That leaves businesses ready, willing, and able to spend once they get the signal that they can do so safely.
2. Households—particularly higher-income households—are sitting on a large pile of savings—about US$2.8 trillion more in Q1 2021 than we had expected them to want under “normal” circumstances before the pandemic.2 Since consumers in aggregate didn’t take on more debt, balance sheets are healthy and consumers quite literally have money to spend. The reopening of the consumer service sector is therefore likely to result in a burst of pent-up spending as people return to restaurants, theaters, sports events, and travel. That’s very different from the normally conservative post-recession behavior of consumers who, even as employment recovers, tend to remain cautious about spending.
3. The pandemic accelerated productivity trends—telecommuting and e-commerce in particular—that were already underway, forcing managers and consumers to adopt new technology with little notice. This may not be the first time that businesses innovated only once they felt severe outside pressure: Economist Robert Gordon argues that the post-World War II economic boom in the United States owes a lot to the financial pressures of the Great Depression and the supply chain pressures of World War II, which forced US businesses to adopt previously existing innovative technologies.3 The future technological revolution may similarly owe much to COVID-19.
4. Government spending will continue to support growth. The pandemic relief bills were instrumental in keeping the economy poised for growth once vaccinations are widespread—even if not every expenditure was an effective use of money. This growth will continue beyond the impact of the latest relief bill if (as we assume) an infrastructure package becomes law. Our forecast assumes that happens, albeit at a spending level substantially smaller than the original White House proposal. But even one-third of the amount President Biden originally suggested would amount to a US$90 billion annual program over a decade: enough to significantly improve the transportation net, reduce cyber risk, fix water systems, and improve the stability of the national electrical grid. The main short-run impact of this spending impulse will be to get the economy back to full employment faster than would occur otherwise and, perhaps, allow the US Federal Reserve (The Fed) to start to renormalize financial markets earlier than we might have previously expected. The long-run impact (perceptible only toward the end of our forecast) would be to raise potential GDP and allow more productivity growth.
The positive picture of the economy comes with structural changes that will challenge some sectors. Although we expect business spending to be reasonably strong, investment in structures—especially office and retail buildings—is likely to lag. Instead, in our forecast, businesses double down on technology investment, buying equipment and software to support more virtual work. And growing e-commerce will mean growing demand for light vehicles and medium-weight trucks for delivery services along with a demand for drivers, gasoline, and related products.
This tells us that the recovery is unlikely to be smooth—or, in some sectors, much of a recovery. Expect economists to invoke “temporary setbacks,” “potholes,” “bumpiness,” and similar language. When you hear that, remember that the long-term trajectory looks pretty good right now. Things will smooth out eventually.
Economic historians have acknowledged pandemics’ impact on economic conditions. Some have even hypothesized that the “Black Death,” Europe’s experience of the bubonic plague in the 14th century, contributed to the start of the industrial revolution in the 18th century.4 The COVID-19 pandemic is, of course, less dramatic and lethal than the Black Death, and vaccinations will limit the time it affects us—even if it takes several years to fully vaccinate the populations of emerging-market countries. But the pandemic’s long-term impacts may take many forms, positive and negative, and will likely continue to surprise us. Our current forecast suggests some of the pleasant surprises that might be in store.
Baseline (55%): Growth remains high in 2021 as vaccinations allow activity to resume in shut-down sectors. Households spend the past year’s savings on pent-up demand for services such as entertainment and travel. However, spending on durables goods stalls as consumers switch back to prepandemic patterns. Business investment continues to grow rapidly, particularly on information processing equipment and software. Investment in nonresidential structures remains weak, however, as the oversupply of office buildings and retail space weighs on the market. Housing construction remains strong but gradually falls, as the current level of construction is greater than population growth can support. We assume Congress passes a spending plan about two-thirds the size of the original administration proposal, including a corporate tax increase. As a result, government spending rises and remains high for most of the forecast. All of this helps elevate demand above the pre–COVID-19 trend for several years. Inflation, however, remains under control (except for a short period in the second half of 2021). This reflects a faster productivity growth through the forecast horizon as the pandemic jump-starts the widespread adoption of new technology. The unemployment rate gradually falls back to below 4% by 2025. The Fed holds rates at close to zero until the middle of 2024, and long-term rates also remain relatively low.
Paging Dr. Pangloss (10%): Dr. Pangloss, a character in Voltaire’s Candide, would repeat that “all is for the best in this best of all possible worlds.”5 Our baseline forecast is optimistic but not Panglossian, with some lagging sectors likely to hold back growth. What could turn out better? Well, the labor force might grow faster than we expect in the baseline, in which we’ve assumed that older people who left the labor force don’t return once the pandemic is over. Government infrastructure spending could be higher, allowing the economy to absorb those additional workers. Consumer spending, particularly for durable goods, could remain stronger. And global growth could recover more quickly, helping to support the US economy (and to keep prices in check). The result: a faster recovery in 2021 and 2022 and continued slightly faster growth over the forecast’s remaining years. Of course, it’s not quite all for the best, as inflation picks up a bit and interest rates move back toward their (higher) long-term averages.
Side effects in post-op (25%): After a burst of spending, the economy hits limits. People continue to be reluctant to reenter the workforce because they have retired or still perceive risks to be high. Operating costs are up due to new procedures instituted to keep the disease in check. Supply chains are temporarily overloaded by sudden changes in demand, limiting production and growth. And some previously valuable machines and buildings are no longer profitable given the new shape of the economy, reducing the amount of capital available to businesses.6 Incipient inflation causes the Fed to raise rates, cutting demand for interest-sensitive goods. By 2022, economic growth slows below potential for several years, and GDP is below the level it would have reached prepandemic by 2026.
The patient relapses (10%): American businesses and households remain complacent about the course of the disease in other parts of the world even as new variants are spotted every week.7 The current vaccines are usually effective against new variants, but the possibility of a variant that requires tweaked vaccines or that spreads more quickly among unvaccinated people remains significant. In our pessimistic scenario, a “variant scare” causes people to return to social distancing and stop purchasing goods and services that are perceived as “risky.” This creates another one-quarter drop in GDP at the end of 2021. A muted government response results in financially stretched business failing and weak balance sheets create the conditions for a more traditional, slower recovery from the recession. This is particularly the case because—after two outbreaks in two years—consumers permanently reduce spending on travel, entertainment, food, and accommodations, requiring a painful readjustment of the economy.
The near-term outlook for consumer spending turns on two big questions:
1. Will consumers spend down all those pandemic-era savings?
In 2020, households saved about US$1.6 trillion more than we forecasted before the pandemic. Some of that went into investments, but many households have a lot more cash on hand now than they normally would want. How much of that will they spend as the pandemic impact wanes? One possibility is that many consumers will remain cautious and hold on to those savings even as they are able to get out and shop. Another possibility: a spending frenzy and, potentially, even a negative savings rate as people finally get the chance to travel, go to restaurants and theaters, and generally cut loose this summer. The baseline Deloitte forecast assumes a modest decline in the savings rate below its long-term level, and that’s enough to support very strong growth in consumer spending this year. But spending could be even stronger if households decide to cash in more of those savings.
2. When consumer services recover, what happens to durable goods?
The pandemic sparked a remarkable change in consumer spending patterns. Spending on durable consumer goods jumped US$357 billion (at an annual rate) between the last quarter of 2019 and the first quarter of 2020, while spending on services fell US$339 billion during the same period. Households simply substituted bicycles, gym equipment, and electronics for food, entertainment, and travel. Once households can again purchase services, will they begin buying fewer goods? There isn’t a lot of evidence one way or another yet, and little to go on in planning for production in the consumer durables sector.
In the longer term, we expect the pandemic to exacerbate existing consumer problems. The pandemic has thrown the problem of inequality into sharp relief, straining the budgets and living situations of millions of lower-income households. These are the very people who are less likely to have health insurance—especially after layoffs—and more likely to have health conditions that complicate recovery from infection. And retirement remains a significant issue: Even before the crisis, fewer than four in 10 nonretired adults characterized their retirement as on track, with one-quarter of nonretired adults saying they had no retirement savings.8 Low interest rates will worsen Americans’ preparation for retirement, while the stock market boom will have little impact on most people’s balance sheets.9
The housing sector outperformed the broader economy in the wake of the pandemic as buyers and sellers found ways to navigate the pandemic’s restrictions. A host of factors combined to boost housing demand in the previous three quarters. These include continued strong economic position of high-wage remote workers, growing expectations that remote work will persist after the pandemic, historically low mortgage rates, and more millennials moving into prime home-buying age.10 Homebuilder confidence has remained above pre-COVID-19 levels but has moderated from its peak at the end of 2020.
Deloitte expects demand to cool due to reduced affordability.11 Nominal home price increases are likely to more than offset the impact of low mortgage rates on demand. And interest rates are set to rise in the forecast as the recovery gathers speed. Despite the slowdown, demand is likely to exceed supply as builders continue to grapple with rising lumber prices and land-use restrictions. Home prices are therefore likely to rise further through the forecast period.
The short-term risk for housing, which was weighted to the upside, is now more balanced. On one hand, slowing population growth means that the demand for housing will grow relatively slowly after the current boom in housing construction. Housing activity might also decline in the later years of the forecast because a considerable chunk of demand has been pulled forward. On the other hand, a decade of under-building, potential stickiness of factors driving demand, and a sizable number of units that require replacement each year might keep home builders busy.12
Long-run fundamentals, however, ensure housing does not become a key driver of economic growth in our forecast. An aging population means that more than a quarter of the nation’s existing owner-occupied homes are likely to become available over the next 20 years as the current owners either pass away or vacate their homes.13
By the first quarter of 2021, business investment was just slightly above the prepandemic level. The overall number, however, concealed some dramatic changes in specific types of capital investment. Nonresidential structures investment was down 17%, and not because of any direct impact of the pandemic—residential construction was up just about the same amount. Investment in just about all categories of residential structures declined, as the business case for office buildings and retail space (for example) collapsed with online shopping and the shift toward working at home.
In contrast, investment in equipment was up 7.5% from the prepandemic level. But most of that was purchases of information processing equipment, while investment in other equipment categories either rose modestly or—in the case of transportation equipment—fell. Investment in intellectual property products rose at about the usual rate, with software (the largest category) accelerating a bit.
We expect this picture—continued strong investment in equipment needed to adjust to the more virtual postpandemic world—to continue over the five-year forecast horizon. Energy may prove an exception, as the already-weak oil market collapsed when the pandemic lockdowns hit. Recovery will likely support structures investment in the next few years. But investment in office and retail space is likely to remain weak for some time, mirroring relatively strong residential construction to meet the demand for larger homes to accommodate more working at home.
Financing investment will remain easy. Nonfinancial businesses are sitting on cash, and interest rates are low. In our baseline forecast, the 10-year Treasury yield remains below 3% for at least five years. Even adding in the potential for a corporate tax hike, the cost of capital remains at historic lows in the forecast. That will give businesses plenty of ability to pay for all those new computers and servers. But even with such easy financing terms, office and retail space will be unable to generate sufficient returns to entice businesses to increase capacity.
Over the past few years, analysts have begun to face the possibility of deglobalization. Global exports grew from 13% of global GDP in 1970 to 34% in 2012, but the share of exports in global GDP started to fall, globalization then began to stall, and opponents of freer trade took power in some key countries—most notably, the United States and the United Kingdom. All this suggested that the policies that fostered globalization might change in the future.
COVID-19 may have accelerated this trend. Although the pandemic is a global phenomenon, leaders have made major decisions about how to fight it—in both health and economic policy—on a country-by-country basis. The most striking examples of this are the US withdrawal from cooperation in the World Health Organization—although President Biden rescinded the move on his first day in office—and the unilateral decisions of both China and Russia to deploy their own vaccines before completing testing.14 As the pandemic surged, the US-China trade war showed no sign of abating.
Although President Biden signed a flurry of executive orders in his first weeks, the new administration has been cautious about overhauling his predecessor’s tariff-heavy trade policy. The White House has shown some interest in returning to a multilateral approach to trade—for example, by supporting Ngozi Okonjo-Iweala for World Trade Organization director general. However, US Trade Representative Katherine Tai has made a point of stating that trade policy should be aimed at helping US workers.15 And the president has kept the Trump-era tariffs in place, likely to use as bargaining chips in future trade negotiations.
Businesses are likely to respond to the ongoing trade policy volatility. One important question is whether businesses will rebuild their supply chains to create more resilience in the face of unexpected events such as the pandemic and the change in US trade policy from the Obama administration to the Trump administration to the Biden administration. It’s impossible, of course, to simply and quickly refashion supply chains to reduce foreign dependence. American companies will continue to source from China in the coming years. But companies will likely begin to reduce their dependence on foreign suppliers or, at least, attempt to use a portfolio of suppliers rather than a single source, even if the single source is the cheapest.
Reengineering supply chains will inevitably mean a rise in overall costs. Just as the “China price” held inflation in check for years, an attempt to avoid dependency on China might create inflationary pressures in the later years of our forecast horizon. And if markets won’t accept inflation, companies will have to accept lower profits in order to diversify supply chains. Globalization has offered a comparatively painless way to improve most people’s standard of living; deglobalization will involve painful costs and may limit real income growth during the recovery.
Deloitte’s baseline forecast assumes relatively strong growth of US exports, and—over the five-year horizon—slightly slower growth of imports (relative to GDP) than in the past. This reflects optimism about the global economy after the pandemic, and some marginal reshoring of production to the United States. The US current account deficit falls from 3.7% of GDP in 2021 to about a relatively high 3.0% of GDP in the last few years of the forecast, reflecting our expectations for continued global demand for dollar assets.16
With COVID-19 relief passed and some certainty about the economic recovery, the Biden administration has turned to focusing on infrastructure. Investing in infrastructure was an oft-stated goal of the previous administration as well, but nothing much actually happened.17 But there does appear to be bipartisan support for increasing spending for infrastructure.
There is not, however, a great deal of agreement over the details. Even the definition of infrastructure is a subject of controversy.18 Is caregiving infrastructure? Preparing buildings for climate change? The amount to be spent—and even how to measure that amount—is also up for dispute. (The proposed Republican plans have included existing spending on infrastructure, while the US$2.3 trillion Biden proposal was all new money, so comparisons are, at best, inexact).
The biggest issue on the table, however, is how to finance the additional spending. President Biden’s plan depends on raising the corporate tax rate to 28% and reversing some of the changes in the 2017 Tax Cut and Jobs Act (TCJA). This is a nonstarter for Republicans, and businesses aren’t thrilled either. The Republican plan states some principles for payment but no specific suggestions. Despite all the sturm und drang around the tax issue, the Deloitte forecast doesn’t assume that any of the tax changes are likely to have a material impact on short-term economic growth. This is a direct consequence of the relatively small impact on investment spending in the two years after Congress passed the TCJA.19
The current state of the congressional debate suggests that (1) a bipartisan plan is unlikely, and (2) a Democratic plan passed through reconciliation will likely be smaller than the president’s proposal, with a more modest rise in the corporate tax rate. The baseline forecast assumes that Congress authorizes spending of about two-thirds the level in the administration’s plan, and that the effective, or average, federal corporate tax rate rises to about 12% from the average rate of about 10% in the past three years. This is still below the effective average federal rate of 15% paid on corporate profits between 2012 and 2016.
The administration has also begun releasing details of a further spending plan (the “American Families Plan”20), focusing on education and income support. Congress is quite far from seriously considering these proposals, although it is possible that some of them might be included in a reconciliation measure focused on infrastructure. Our current forecast, however, assumes none of these proposals will become law during the five-year forecast horizon.
Our forecast assumes deficits will fall by 2022 to about US$1.5 trillion per year. That’s a hefty amount, one that inevitably raises the question of whether the US government can continue to borrow at such a pace. The answer is that it can—until investors lose confidence. At this point, most investors show no sign of concern about US debt. In fact, very low interest rates on US government debt indicate the world wants more, not less, American debt. We anticipate no problem over the forecast horizon.
But the government will face a crisis if it does not eventually find ways to reduce the deficit and consequent borrowing. The crisis may be many years away, and current conditions argue for waiting. It would be a bad idea to wait too long once those conditions lift.
The conversation about labor markets has switched—and fast. Not long ago, employment was about 10 million below the prepandemic level and the main question was how difficult it would be to get all those workers back on the job. Now business commentary is full of talk about labor shortages and stories about employers struggling to find workers. That seems a bit odd since employment is still down about 8 million (and that doesn’t include the growth of the population over the past year).
Pundits have seized on several reasons why businesses are experiencing so much trouble hiring workers:
As is the case in many areas, the pandemic accelerated trends that were evident before it started. Slow labor force growth and continued high demand had already created conditions that required companies to offer higher wages to lower-skilled workers and to be more imaginative about hiring.22 In the post–COVID-19 world, companies that make extra effort to find the workers they need and provide conditions to attract those workers will have an important competitive advantage.
Deloitte’s baseline forecast assumes that job growth is very strong over the next two years as employers do, in fact, find and rehire those 8 million missing workers (and more). The unemployment rate falls, albeit slowly at first as people reenter the labor force. Over the longer horizon, labor force growth slows to just 0.2% per year, presenting continuing challenges for employers.
The Fed’s operations have been one of the bright spots of the US response to the pandemic. When the virus first began spreading, there was a significant possibility that a financial market meltdown would exacerbate the country’s economic problems. The Fed’s prompt and strong actions kept financial markets liquid and operating, preventing that additional level of pain.
There was a cost, of course: the Fed’s intervention in many different markets. The traditional concerns about the Fed buying private assets have gone out the window, and the Fed has created methods for direct lending from US states, counties, and cities (Municipal Liquidity Facility), small and medium-sized businesses (Main Street Lending Program), and purchases of corporate bonds (Primary and Secondary Corporate Credit Facilities).23 This is unprecedented: The Fed has traditionally avoided lending directly to nonfinancial firms. Other programs are aimed at stabilizing specific financial markets. Although the volume of lending for many of these facilities is still at a small fraction of the announced level, the Fed’s willingness to lend has calmed credit markets.
In the longer term, the Fed will want to wean markets off its aid. Fed officials have begun to discuss “tapering” their purchases of securities. “Tapering” and reducing the Fed’s inventories of these assets will precede hiking the Fed funds rate. We have assumed that the funds rate begins rising only in 2024. This is later than some commentators (not to mention futures markets) expect but consistent with Fed officials’ statement of their intent.
We expect long-term interest rates to start rising earlier—in fact, they slowly rise over the next few years. However, continued low inflation puts a lid on long-term rates: In the baseline, we forecast the 10-year Treasury yield to settle in around 2.7% after 2025.
Of course, interest rates are always the least certain part of any forecast: Any significant news could, and will, alter interest rates significantly.
Talk of inflation picked up when Larry Summers published his analysis of the proposed relief bill before its passage.24 Summers focused his concerns on the fact that the gap between the economy’s capacity and actual production was about US$670 billion at the end of 2020, while the proposed bill totaled US$1.9 trillion. That suggests that GDP could be pushed up quite a bit above capacity in 2021 (assuming the entire amount is spent in one year), leading to shortages and, ultimately, higher inflation.
Arguments over the amount of excess capacity in the economy have given way, however, to concerns about commodity prices and the apparent labor shortage. Commodity prices are not, in fact, a good indicator of future consumer prices. Commodity prices have shot up before with little significant impact on long-term inflation, and there’s not a lot of evidence that the current runup is very different from those in the past.
The idea that there is a labor shortage is inconsistent with the large number of unemployed. Whatever the reasons for this, there is plenty of room for hiring once businesses figure out how to reach out to workers. But even when labor markets truly tighten—as they were before the pandemic—risks of inflation are lower than many commentators think. It’s clear that—contrary to the experience of the 1960s and ’70s—the US economy today can operate for extended periods of time above what many economists believe is capacity without generating inflation. In the late 1990s, and then again in the late 2010s, the unemployment rate fell quite a bit below the level that economists thought was consistent with stable inflation. At other times, the unemployment rate was very high. Yet through it all, inflation remained within a narrow 1.5% to 2.5% band. That experience argues strongly that sustained inflation is unlikely.
That’s not to say that inflation spikes might not happen. Just as the pandemic created a sudden shutdown of some sectors of the economy, vaccination is likely to boost demand in many of those same sectors. The price for airline seats this summer might well spike as newly vaccinated Americans head out for long-delayed travel, while airlines struggle to rebuild their service networks. But inflation requires that such price spikes stimulate higher prices in other sectors, and that the need to raise prices be built into the economy. There are no signs this is likely in today’s economy. Deloitte’s baseline forecast expects core consumer price inflation to remain at very close to the 2% level over the entire forecast horizon, with total consumer prices rising a bit faster in 2021 because of the recovery of oil prices from their pandemic lows.
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