At risk of overheating

SHI YU/CHINA DAILY

The Joe Biden administration's $1.9 trillion stimulus promises to drive the US economy to grow too strongly, with the rate of growth expected to be around 6.9 percent to 7 percent. This will trigger structural inflation, and changes to inflationary expectations, market expectations and market interest rates in particular, which will force the US Federal Reserve to implement contractionary monetary policy.

This will likely have a massive impact on the global economy, which will in turn cause shocks to the US economy and the financial sector. The overheating of the US economy and the hovering of the sword of inflation are the biggest uncertainties in 2021 that merit close attention.

As a result of the overheating, the actual output of the US economy will surpass its potential output. It is estimated that the actual GDP growth of the United States will overtake its potential growth level by the end of the second quarter, reaching three percentage points higher than the potential growth in the third quarter, and continue this strong momentum in the fourth quarter.

In terms of the US' overall economic mix, the tertiary sector dropped sharply last year, but will see a big rally this year with inadequate overall supply. As far as aggregate demand is concerned, given that the US is a consumer-driven economy, the continuous cash stimulus will lead to a strong rebound in consumption and excessive growth in aggregate demand. Overheated aggregate demand coupled with insufficient supply will cause prices to rise. Hence, inflation is a high-probability event.

The COVID-19 pandemic has resulted in severe labor shortage, high unemployment rate, and declining labor participation ratio. All these factors added together will surely trigger structural inflation at the least. For the moment, it is not clear whether this structural inflation will be just temporary or transitional, and it is hard to draw a conclusion as to whether this structural transitional inflation will develop to be all round inflation, but the potential risk does exist.

An important question is how the Fed will respond to the structural and temporary price rebound, or rather price spike. The Fed's task is to keep inflation at a target rate of 2 percent. Previously it is always below the target but this year it is highly likely to exceed the target ratio of 2 percent. Whether the Federal Reserve will raise interest rates or not is a question of great relevance to all countries. Yet it is uncertain as yet how the Federal Reserve will act.

This is bringing tremendous risks and uncertainties to the market. How has the market reacted? As we can see, the structural inflation has already driven up the market interest rates. That explains why the price for US 10-year Treasury bonds went up in March. We have seen changes to inflationary expectations, albeit only preliminary and tentative changes. After the $1.9 trillion stimulus injected into the economy, what kind of effects will it have? This requires our special attention.

The gradual rise in Federal Reserve interest rates will have a significant impact on the global economy. The thing is that the rise of inflation is bound to depress the stock market, causing the stock and bond markets to move in the opposite direction. While in the context of industries and enterprises, the already narrowing interest margin of credit bond will widen once again, as was seen in early 2001, resulting in imbalances between market and enterprise liabilities.

The biggest problem resulting from rising interest rates is fiscal instability. Currently there has been the paradox of government debt and interest cost. Government debt in developed countries grew by nearly 15 percentage points last year, but the ratio of interest costs as a share of GDP has dropped because of the zero interest rate. Only in developing countries are interest rates rising, which leads to escalating interest rate costs for governments. A one-percentage-point rise in interest rate means the same increase in the interest payment for governments. If the government debt exceeds certain levels, public finance will become unsustainable and severely affected. This is even more so in emerging economies.

As far as this year is concerned, the overheating entails high potential risks. Even if there is no inflation in 2021, what about 2022 and beyond? The US fiscal deficit will continue to grow, interest rate changes will become extremely sensitive, and the market is already highly nervous. What's more, the US is faced with a number of deep risks. After the overheating, the US economy will encounter the risk of drastic decline, which is why Biden is insisting on launching the $3 trillion investment program. The economic rationale is that once implemented, fiscal stimulus cannot be stopped but continue on and on; otherwise, the economy will decline. We have witnessed the overheated potential growth rate in the US that triggered the 2008 global financial crisis. Once the sluice of fiscal stimulus opens, it is very difficult to maintain a stable economic landing. It is even more challenging to exit the current stimulus if another round of stimulus is to be launched.

We have seen that the US economy has become increasingly more dependent on services and consumption in the wake of the COVID-19 pandemic. The structural problems faced by the US economy include severely inadequate supply of manufactured goods, weakening resource allocation capabilities of financial markets, the decoupling of financial services from the real economy, insufficient investments in the real economy, declining growth in labor supply, and drastic deterioration of income distribution. A string of these structural problems cannot be solved by simple stimulus, but instead require supply-side structural reforms. In this sense, if these fundamental problems cannot be resolved, the "overheating" will eventually move toward "crisis".

The author is chairman of the National Institute of Financial Research at Tsinghua University and former deputy managing director of the International Monetary Fund. The author contributed this article to China Watch, a think tank powered by China Daily. The views do not necessarily reflect those of China Daily.