• While vaccine success has brightened the 2021 economic outlook, the first quarter is less certain amid surging cases and renewed lockdowns
  • The labor market has recovered approximately 60% of lost jobs since the pandemic began, and a potential rise in YoY inflation metrics in March/April is unlikely to impact Fed decision making
  • If vaccine distribution boosts 2021 economic growth as expected, we believe the first likely response from the Fed is a reduction in asset purchases at some point this year

Positive developments on the vaccine front at year-end fueled optimism in economic and market circles that the proverbial ‘light at the end of the tunnel’ was in sight. While the 2021 economic outlook is more upbeat, the first quarter presents greater uncertainty. Vaccines are expected to become widely available to the general public by June, if everything goes according to initial plans. These plans rely on operational/administrative efforts by federal, state, and local government officials, and vaccine distribution has, so far, underperformed expectations. For example, Operation Warp Speed predicted 20 million Americans would be inoculated by the end of December 2020. However, as of January 2, 2021, less than 5 million had received the first dose according to CDC data. The combination of the resurgent virus outbreak, subsequent lockdowns, and slower vaccine rollout casts a shadow over the recovery to start the year. The $900+ billion COVID aid package passed by Congress before year end helps somewhat, but it’s far less than the $2.2 trillion CARES Act that buoyed Q3 2020 GDP growth. Congress could decide on another round of aid with support from the new administration following the inauguration later this month.

Strong job growth from May through November bolstered the labor market recovery from the initial COVID-related fallout, but as Exhibit 1 illustrates, there is still much more job growth needed to get to pre-pandemic employment levels. The chart provides data from the two major employment surveys and, on a percentage basis, the recovery to date represents 55-65% of jobs lost in March and April (December data to be released January 8). As is typical with most deep recessions, there is some level of structural employment that may persist for a prolonged period. In other words, the labor force participation rate could hold below pre-COVID levels for some time. There is much debate as to whether the headline unemployment rate will be able to reach a sub-4% level anytime soon.

On the inflation front, consumer price gauges (CPI & PCE) remain stubbornly below the Fed’s 2% target, but there is a likely chance that the year-over-year measures temporarily breach that threshold in March or April simply due to the base effect. In other words, the crash in inflation measures in the initial stages of the pandemic present a low bar for year-over-year comparisons, but it should settle back below 2% as the year progresses, barring an unexpected spike in consumer prices.

Fed Policy

We begin 2021 with a Fed balance sheet of $7.36 trillion, an increase of more than $3 trillion over the prior 12 months. The Fed continues to purchase Treasuries and MBS at a monthly pace of $80 billion and $40 billion, respectively, with no signs of tapering soon. The December 16 FOMC official statement included new guidance related to changes in the asset purchase program, noting that the current pace would continue “until substantial further progress has been made” toward the Fed’s dual mandate of price stability and full employment. As discussed above, the labor market still has much ground to cover in reaching pre-pandemic levels of employment, and price inflation is unlikely to be an issue in 2021. Regarding the latter, the September change in the Fed’s policy framework to pursue average inflation targeting should lead to a longer lag on any removal of monetary accommodation. To be clear, we believe a tapering of asset purchases would almost certainly come before any changes in interest rate policy, but the base-case expectation of many analysts is for no reduction in asset purchases until the second half of 2021, at the earliest. If a much larger fiscal aid package is passed in Q1, does that make the Fed more comfortable in reducing its presence sooner than currently expected? There have been no hints of this thinking by Fed Chair Powell, so we would not consider it a high probability at this point. 

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