Toys, cars, and the U.S. recovery

Putnam Fixed Income team, 06/10/21

  • Consumers, buoyed by stimulus money, lift goods purchases in stores and online.
  • Business investment has been rising but at a reduced pace as firms eye costs.
  • The Federal Reserve’s June dot plot could signal rate hikes as soon as 2022.

Amid the debate on inflation, the U.S. economy is showing signs of moderating. We analyze a confluence of factors — including inflation, real economic activity, and Federal Reserve policy — that could determine if the easing is temporary or cyclical. We believe growth in the United States remains strong, but expectations need to be revised down.

Inflation and moderation

Inflation is one of the reasons behind the slowdown. Households and companies are still trying to adapt to the new environment created by the pandemic. This structural shift has created unusually, and temporarily high, demand for some goods and services. This demand, along with fiscal and monetary support, has propelled prices higher. However, as prices have risen more than household incomes, people have turned cautious and selective. Consumption dropped slightly in real terms in April after the stimulus-induced spending in March.

Why have households slowed purchases given the extra savings? The economic theory is pretty clear: People spend over time. People typically have a strong preference to smooth their consumption out. Unless stimulus checks keep coming and consumers are certain of future government payouts, they are likely to spend gradually over time. The extra funds should sustain economic activity over a longer period, even if higher prices slow the recovery in the near term.

labor market data

Fiscal stimulus has disproportionately raised demand for goods that lower-income households tend to buy. We have seen this in the demand for used cars. Still, not all households have benefited from government stimulus. For those households, the rise in savings was mostly precautionary in nature. As Covid-19 fears fade, those precautionary savers will likely start spending more, especially in services.

The third main source of demand, pandemic-induced spending, might have already played out. There was a structural shift toward goods spending during the pandemic. Households bought more electronic equipment to work and entertain at home, cooking tools, sporting goods, toys, and more. Some of the past goods purchased are likely to be a drag on future consumption. We believe that going back to pre-Covid-19 spending patterns might take years, rather than months or quarters.

Assessing capital spending

Similarly, there have been unusual patterns of capital spending by businesses during the pandemic-induced recession. Many companies changed their business models to be able to operate under mobility restrictions. This required companies to purchase new equipment, machinery, and technology. It was essentially an involuntary capital expenditure.

It is highly likely the corporate sector brought forward some future investment plans while trying to adapt. As life normalizes and firms better adapt to the new circumstances, their willingness to invest might somewhat weaken until they see the sustained rise in demand. This might be why business investment has been rising but at a reduced pace.

The Fed’s role in economic activity

The Fed’s policy is part of the economic story. Economic activity may not boom as much as previously thought. Can or should this be a good rationale for the Fed to stay dovish? The Fed’s policy framework emphasizes maximum employment and stable inflation; but a framework designed with the assumption of constrained fiscal policy is not relevant anymore, in our view.

Minutes from the Federal Open Market Committee (FOMC) meeting in April show that some members suggested reviewing the pace of asset purchases. Assuming that a taper decision is already in the books, the pace and composition of the taper will matter more for the markets. If economic growth stays strong and is supported by fiscal policy, the pace can be reduced faster than in 2013 and 2014.

If the recovery continues without any major disruption, the Fed may next discuss the timing of interest-rate hikes. The Fed’s dot-plot projections changed little in March, with most members expecting to keep rates near zero through 2023. (The dot plot maps the Fed’s monetary policy path.) We believe the dot plot in June could indicate rate hikes in 2023, with some officials projecting rate rises starting in 2022.