Outlook and Market Review – Second Quarter 2021

The U.S. economy grew 6.6% in the second quarter following a 6.3% growth rate in the first quarter of 2021, based on the revised estimates by the Bureau of Economic Analysis. The economy lost momentum but GDP is now slightly above the pre-pandemic level. The unemployment rate fell to 5.2% in August from 6.3% in January of 2021. Job growth has been uneven but about six million of the estimated 10 million jobs lost in the pandemic have been gained back. At the current average of monthly job gains, the pre-pandemic level of employment should be reached by the third quarter of 2022.

Inflation picked up in the first six months of 2021 at an annualized rate of about 6%, well above the 2% target for price stability goals. The second quarter GDP price deflator was 6.22% and both the headline Personal Consumption Expenditure (PCE) and Consumer Price Index (CPI) in the second quarter are in line with the deflator. Wages and interest rates have not kept up with inflation. Real hourly compensation fell 4.6% in the second quarter and declined 2.7% on a year ago basis. The Treasury 10-year bond yield is hovering around 1.3%, which is below the generally accepted real rate of return on capital without inflation. Ex post real rates, the difference between the nominal rate and realized inflation, have been negative for some time. In the second quarter, the 10-year bond’s realized yield was approximately a negative 5%. This set of circumstances in not sustainable, but policy makers are betting on the “transitory” nature of inflation rather than an inflation trend. The Fed is willing to overlook temporary deviations from the 2% inflation target for short periods of time, especially if the economic recovery is weak. The Fed intends to slow its bond purchasing program in November. Nevertheless, there is a good chance that a slow third quarter and lingering slowdowns from the Delta variant of COVID will lead to very small tapering.

Eventually, there will be a showdown between the current administration’s goals for increased debt creation from government spending and any tapering of the Fed’s debt purchasing program. Without the Fed’s artificial manipulation of credit markets, interest rates should pick up significantly due to the dual role of higher inflation expectations and excess supply of government debt at current rates. The Fed is working on a definition of “maximum employment” consistent with stable prices. This unemployment rate is likely to be in the range of 3.8% to 4.2% if inflation is on the 2% target. If the economy is to move to this lower level of unemployment there must be a structural change in the labor market. The problem is not the lack of employment opportunities. Job openings and quit rates are al all-time highs. Employment gains now require more job seekers rather than employment opportunities. This is not an issue that stimulation from either monetary or fiscal policy is likely to affect. A key drawback for increasing job seekers is the unknown future for COVID and its variants. The science cannot tell us if the future and aftermath of this pandemic will be temporary.

Sentiment and confidence indicators tanked in August, partly due to concerns for the Delta virus variant and inadequate vaccinations. Other factors weighing on confidence include the aftermath of the poorly planned exit from Afghanistan, inability to adequately screen and control immigration, loss of energy independence, stalled negotiations for fair trade, dependence on China in the supply chain, pending bankruptcy of the Social Security Trust Fund, mounting debt burden, and potential for renewed terrorism from the Middle East.