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The possibility of an economic boom this year has stoked worries about higher inflation and prompted a sharp selloff in US Treasuries. We spoke with fixed income portfolio manager Pramod Atluri and US economist Darrell Spence about the outlook for the economy and interest rates, and whether the market could force the Federal Reserve to tighten monetary policy sooner than expected.

Darrell, let’s start with you. What’s behind the current expectations, and how fast do you think the US economy can grow in 2021?

Darrell Spence: It’s all about the stimulus. The $1.9 trillion coronavirus relief package, which sends more than $400 billion directly to consumers, should provide a powerful tailwind for growth. All of that money hitting the economy at once is powerful, and gross domestic product growth could be pretty spectacular. There are also unspent funds from prior relief packages, plus a vaccination timeline that currently puts the US somewhere in the second half of August for achieving full vaccination of the over-16 population. As that timeline compresses, the economy should open further. Finally, the Fed has said it will view near-term inflation as transitory and remain accommodative.

I think all of this could drive a quarter or two of growth of around 10% this year. Supply chain bottlenecks and residual weakness in the labour market could be impediments to reaching that level, but high-single-digit growth is very likely in 2021.

We’re seeing many signs of economic acceleration. Look no further than the recent surge of US consumer spending on pleasure boats. While some American families have saved their stimulus payments, as reflected in a savings rate close to 15%, others have essentially viewed them as a bonus. While purchases of pleasure boats is a signal of high-end spending, we’re starting to see a more broad-based increase in consumer spending as well.

Given the economic outlook, the market has grown concerned about inflation. Do you share that concern?

Darrell Spence: I agree with the consensus that inflation will rise this year, but a lot of that is likely to be temporary. We’ll be lapping last year’s super-low inflation, massive stimulus will be hitting the economy, and supply chain bottlenecks may drive some upward pricing pressure. I think we could see the consumer price index in the area of 2.5%.

These things will probably play out by the end of this year, and then inflation should get back to a longer-term trend rate. I don’t expect it to stage a major breakout. But it could persist a little bit higher over the longer term, especially if there is more fiscal support in the form of a large infrastructure bill.

It’s clear that the market is already sniffing this out. That's why TIPS (Treasury Inflation-Protected Securities) breakeven rates, which measure inflation expectations, are elevated. But inflation would have to really take off for expectations to rise meaningfully from here. At this point, a market pricing in 2.6% inflation doesn’t seem to be worrying the Fed.

Pramod, given this backdrop, where do you see interest rates moving over the next year?

Pramod Atluri: With the 10-year Treasury yielding almost 1.75%, interest rates at the long end of the curve are back to pre-pandemic levels — a time when US growth and inflation were both trending at around 2%. That was a late-cycle economy that looked tired in many respects. Today, the economic environment is vastly different. So it makes sense to me that interest rates could move higher, although the bulk of the repricing has already occurred.

 

1. Source: Bureau of Economic Analysis, Refinitiv Datastream. As at 28 February 2021. Gray bars denote recessions as determined by the National Bureau of Economic Research.

2. Source: Bloomberg. As at 26 March 2021.

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