Two narratives about how recovery from the COVID-19-driven economic downturn will play out are competing in the business press – the Federal Reserve’s and that of the financial markets.
Market economists typically forecast wider changes in quarter-over-quarter gross domestic product (GDP) than their counterparts at the Fed. But the current discrepancy is wider than it has been in decades. This is creating so much confusion in financial news that a recent edition of Squawk Box discussed the extent to which “markets seem reluctant to believe the Fed’s policy goals.”
The markets see recent GDP growth as closely aligned to stock market performance: a dramatic drop in the second quarter of 2020 and an equally dramatic recovery from third-quarter 2020 to third-quarter 2021.
The Fed sees GDP as driven by structural economic considerations that move only gradually from quarter to quarter. As a result, the Fed estimated a smaller drop in GDP for second-quarter 2020 and a slower recovery ever since.
Over the last year, the Fed view was proven right multiple times.
“Triple-I’s forecasts fall within the consensus central banks view, as represented by the Fed for the U.S. and the International Monetary Fund (IMF) for the large insurance markets we follow,” said Dr. Michel Léonard, Triple-I vice president and senior economist. He said the expectations gap comes down to three economic considerations:
- Fiscal stimulus and GDP growth: Fed and market economists disagree about the extent of the relationship between fiscal stimulus and growth. When generating GDP forecasts, all economists assign a “multiplier” to quantify the impact of government spending on GDP growth. Market economists tend to assign larger multipliers than central bank economists. Given the historically high fiscal stimulus of the last 12 months, market economists expect historically high GDP growth.
- Shifts in economic output: They also tend to weight quarterly data differently. Fed economists focus more heavily on quarter-to-quarter trends, and market economists on changes within quarters. The COVID-19 economy upended how certain activities are carried out and reduced the comprehensiveness of quarterly data. For market economists, this led to overestimating the decrease in activity in the second quarter of 2020 and now overestimating the increase in first and second quarter 2021.
- Timing: The Fed and markets agree broadly about GDP growth but disagree on timing. Both expect a comparable amount of growth between now and 2023 but, for the reasons above, allocate it differently across 2021, 2022, and 2023. Market economists allocate most of the growth to 2021, while Fed economists spread it over the 2021-2023 period. This has led to the Fed forecasting higher growth in 2022 than some markets economists.