By Atul Bhatia, CFA
Both the Fed and the market are estimating a sharp spike in economic activity and inflation in the coming months, driven by the $1.9 trillion fiscal stimulus, economic reopening releasing some or all of the accumulated $1.6 trillion in excess consumer savings, and year-over-year comparisons to a largely shut-down global economy. These forces are powerful but potentially ephemeral. Stimulus payments are generally one-time or short-lived in nature and the majority of economic gains during the pandemic have accrued to investing households who tend to save at a higher rate than the median. After an initial bout of spending, these households may well return to saving. For these and other reasons, the Fed has already telegraphed that it will discount near-term price spikes and instead wait for confirmation that inflation expectations are well-entrenched at or above target level. This is likely a multiyear process as the Fed evaluates business and consumer trends.
President Joe Biden’s $2.25 trillion infrastructure plan—if enacted—could speed the Fed’s decision-making. The plan has two critical attributes: first, it is a multiyear spending plan, so it has a higher chance of impacting underlying inflation expectations; second, fiscal policy gains will likely be less heavily skewed toward investors than monetary policy gains. Rising wages to lower-income households are typically spent immediately, potentially creating the type of self-sustaining inflation the Fed wants.
The infrastructure bill will likely be subject to considerable revision during the legislative process and may never pass into law. Whatever its final form, the key considerations for the Fed are likely to be the magnitude and duration of the spending plan and the distribution toward higher consumption, lower-income households. The more pronounced and durable the fiscal impact, the greater the Fed’s flexibility to adjust monetary accommodation. We believe long-term investors will be well-served to focus on the infrastructure plan and its ramifications and de-emphasize the large, but expected, increases in near-term inflation.
Infrastructure funding and debt
In addition to the spending aspects of the plan, there is considerable uncertainty around its funding. The plan calls for higher corporate taxes to cover the bulk of the costs. Even if Congress were to raise the statutory corporate tax rate, the effective rate for large corporations will likely remain well below that mark. According to the Treasury Department, U.S. multinationals currently pay less than eight percent of earnings to the U.S., despite the 21 percent corporate tax rate; under the prior 35 percent tax regime, actual collections amounted to only 16 percent. As a result, legislation notwithstanding, a large portion of any spending plan is likely to be funded by government borrowing.
Effective corporate tax rate well below statute
1987 – 2020
The chart shows a nearly seven-fold increase in corporate profits from approximately $300 billion in 1987 to $2 trillion in 2020. During the same period, taxes paid by corporations only doubled, leading to a decline in the effective tax rate from 30% to 9% during the 33-year period.
Source - RBC Wealth Management, St. Louis Federal Reserve
But with nearly $22 trillion—or just over 100 percent of U.S. GDP—in existing federal debt, some in Congress have questioned the sustainability of additional borrowing. In testimony to the Senate, Treasury Secretary Janet Yellen addressed those concerns in part by highlighting that low interest rates keep debt servicing costs down and allow the U.S. to comfortably manage higher debt-to-GDP levels. This position has also found support from former Treasury Secretary Lawrence Summers, an outspoken critic of current policy. In a paper written late last year, he suggested that debt-to-GDP was an inappropriate measure and that keeping inflation-adjusted debt service costs—currently near 0.5 percent in the U.S.—below two percent of GDP was a better target.
To some degree, this choice between debt-to-GDP and debt service is a false dichotomy. The larger the debt-to-GDP ratio, the greater the impact of a rise in borrowing costs and the more likely and quickly debt service costs rise above the two percent level. For the U.S., with debt-to-GDP near 100 percent, the Summers’ analysis would imply the need for Fed policy to keep inflation-adjusted government borrowing costs below two percent and potentially lower as debt-to-GDP increases.
Higher debt tolerable with lower real rates
1943 – 2050E
The line chart shows a steady decline in federal debt from 100% of GDP in 1945 to 25% in the mid-1970s. The measure rose sharply beginning in 2009 and is at 100% and the CBO projects it to rise to 200% by 2050. The chart also shows that these higher debt-to-GDP levels are tolerable with lower real interest rates and that by 2051 real interest rates of 1% may be desirable.
Source - RBC Wealth Management, Congressional Budget Office (CBO)
Fed policy constrained in a different direction
A focus on federal debt service costs would imply the need for a different type of monetary accommodation. Rather than attempt to stimulate demand by pushing bond yields and credit spreads down across the board, the Fed would be able to more narrowly focus on Treasury funding rates and inflation. It could likely accomplish a two percent real rate with a more normalized interest rate policy, although potentially with added emphasis on asset purchases and with a consistent tolerance for higher inflation.
A rejuvenated fiscal policy has the potential to achieve the Fed’s employment and price goals more quickly than monetary policy can accomplish, theoretically freeing the Fed to reduce accommodation. At the same time, based on how fiscal policy is funded, the Fed may face a new set of limited constraints against rates rising, this time in the form of federal budgetary pressures. As a result, the Biden infrastructure plan has the potential to improve the existing, highly supportive policy framework, by allowing for monetary policy normalization with potentially limited impact to asset prices.