HomeThe U.S. Economy at Risk Of Overheating

The U.S. Economy at Risk Of Overheating

To many, the speed of the economic recovery taking place in the United States is surprising. As reflected by the strong NFP report last Friday, the U.S. labor market is creating far more jobs than expected – close to 1.7 million new jobs in the first quarter alone. 

More jobs reflect a performing economy. In turn, a performing economy should be met with contractionary monetary and fiscal policies. However, neither monetary or fiscal authorities plan to end the accommodative measures, and that leads to what economists call an economy that is “overheating”.

The best way to interpret the economic recovery is to compare the air travel passenger volume registered recently with the February 2020 average. As it can be noted, green dots appear on the U.S. map, and they will increase in numbers as the vaccination campaign advances.

Hence, overheating is not out of the question. But why is it a bad thing for the economy?

Why Is This Time Different?

In normal economic conditions, policymakers would want to avoid economic overheating. To exemplify, think of the PMI survey. This is a survey that reflects how a certain economic sector (e.g., construction, manufacturing, or services) performs, and the line in the sand is 50. Anything above shows a sector that expands, anything below a sector that contracts.

However, economists would rather want to see levels above 55 but below 60, as anything above 60 shows potential overheating. When this happens, authorities intervene to cool the economy down and to avoid a so-called “hard landing”. Moreover, overheating leads to higher inflation, which, in turn, may undermine the price stability mandate of most central banks.

However this time, it is, indeed, different. The COVID-19 pandemic triggered unprecedented actions from monetary and fiscal authorities. The most impressive one is that the Fed actually changed its price stability mandate and now considers averaging inflation around the 2% level, rather than an absolute target.

As such, higher inflation as a result of overheating is actually desired by the Fed. How about bubbles, such as the one suggested by the existing home sales? The sector reached levels not seen since the 2008-2009 Great Financial Crisis triggered by….the housing sector.

It is different, though, because of the tremendous exogenous shock the economy received during the pandemic. Moreover, the inequality gap widened, making it difficult for most Americans to cope with the new reality without accommodative measures remaining in place.

Hence, the Fed and the U.S. administration will allow the economy to overheat for some time. The benefits of doing so outweigh the risks of tightening financial conditions too early.

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