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How Much Stimulus Does the Economy Need?

Published on: Oct 28 2020

The big question now is by how much will economic growth decline?

The economy had a strong bounce off the bottom in April because of significant stimulus from both the Fed and Congress. The United States probably had the most significant stimulus measures of any economy, and they were put into effect quickly.

The stimulus was followed by big surges in technology, manufacturing and goods-related industries. A number of professional services firms were able to operate remotely and had steady demand.But a large portion of the economy didn’t participate in the surge.

Sectors that recovered only a little or not at all include travel, entertainment, leisure and portions of health care.

It is unlikely those sectors will see much growth from here, absent a vaccine or changes in behavior. Services are about 70% of the economy, and the services sector suffered the most in the downturn.The fiscal stimulus replaced a lot of the income that was lost when businesses closed, and workers were laid off or chose not to work because of health concerns. But the stimulus expired at the end of July, and there was not an agreement to replace it as of mid-October.The data show that growth slowed after July. I expect that the recovery from here will be very weak without further fiscal stimulus to replace the lost income.

The risk is that businesses adapt to the lower level of activity and assume it will be permanent. They will reduce their investment spending and hiring. That could cause a compounding effect on other businesses that slows growth even more or turns it negative.

Businesses and individuals aren’t willing to borrow much, even at near-zero-per-cent interest rates, because they’re afraid of weak growth.

The Fed and other central banks exhausted most of their tools after the financial crisis. They have limited power to stimulate growth. Coordinated fiscal and monetary policy are needed, as Fed Chairman Jerome Powell and other Fed members recently emphasized.Despite slowing economic growth, most investment markets have done well.

That’s because a lot of the stimulus from the Fed and Congress made its way into financial assets. The Fed’s monetary stimulus, in particular, helps the financial markets more than the economy.

That has created quite a gap between the economy and financial markets. Markets had historic surges following the lows of the spring, and their growth continued. But the economy’s growth quickly leveled out.The gap between the markets and economy can’t continue indefinitely. Either the growth rate will increase or financial assets will decline. Inflation increased in recent reports, but the price increases aren’t broad-based. The goods that people hoarded or demanded more of during the pandemic rose in price.

Many other prices were steady or declined.

Also, people have been afraid to spend. A substantial portion of the stimulus payments were saved or used to pay down debt, according to several analysts. The overall savings rate in-creased.But general price inflation is likely to rise steadily because of the monetary stimulus. A significant rise in inflation could be three or more years away, but the Fed made clear it won’t try to contain inflation until it has been above 2% for a while. Higher inflation should push prices of stocks, gold and other assets higher over time.There rarely has been as much uncertainty in the markets and economy.

In addition, change happens much faster these days. This year, we had the shortest bear market in history and had a recession declared faster than ever before.It will be tough for investors to anticipate or keep up with changes in the markets and economy. That’s why I continue to recommend a diversified portfolio. Instead of anticipating markets, have investments that will do well in different environments.

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