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We're Expecting Higher GDP Growth--and Higher Inflation Too

We've increased our U.S. GDP growth forecast.

We’re increasing our 2021 U.S. real GDP growth forecast to 6.2% from the 5.3% we expected in our last update in February. The main reason for the upward revision is a faster-than-expected U.S. consumer recovery. We now expect 7.5% real consumption growth in 2021 versus 6% previously.

We’re also increasing our 2021 inflation forecast, although we think the Federal Reserve will have little trouble keeping inflation under control.

U.S. Consumer Data Points to Faster-Than-Expected Recovery

Since our February update, the consumer data released in the last two months has been surprisingly strong. First, goods consumption/retail sales has been stronger than we expected, in part because consumers have spent a large share of their stimulus checks. Retail sales jumped in January and March in response to each wave of stimulus check disbursement.

Second (and equally important), it appears that the consumer services recovery is now proceeding rapidly. While personal consumption in services was essentially flat in January and February, we expect March data (to be released at the end of April) will show a sharp uptick. The restaurants and bars item of the retail sales release shows a 13% gain in March, with spending now just 5% below prepandemic levels. Likewise, the recovery in U.S. airline traffic indicates a normalization of consumer services behavior.

Originally, we had thought there was a good chance that consumer services could prove sluggish until the arrival of herd immunity in the United States (which we expect to occur around the beginning of June). By contrast, the recent data suggests that consumer services spending may recover most of the way to prepandemic levels even before the arrival of herd immunity. With around 40% of Americans having received at least the first dose of a COVID-19 vaccine as of April 19 (and average new cases having fallen around 70% since the January peak), consumers are responding to the diminished risk of illness by normalizing their behavior.

As we have discussed before, a consumer services recovery is vital for the overall economy. As of the fourth quarter of 2020, consumer services expenditure accounted for the entire U.S. GDP shortfall versus prepandemic levels. Also, a consumer services recovery should lead to a near-complete recovery in the job market.

Altogether, we now expect 7.5% real consumption growth in 2021 versus 6% in our last update in February. Faster consumption growth is the main driver of our increased overall GDP forecasts. We now expect real GDP growth of 6.2% in 2021 versus 5.3% previously. Our growth forecasts for 2022 and later years are largely unchanged. We now expect U.S. real GDP growth to surpass our pre-COVID forecast by 2% by 2024.

Our latest GDP forecasts are roughly in line with the consensus average, which calls for real GDP growth of 6.1% in 2021 and 4.4% in 2022. Some forecasters expect up to 200 basis points greater growth than we do through 2022. However, we’re skeptical as to whether the economy’s productive capacity (or potential GDP) can accommodate an increase in output to that level. Fiscal stimulus and other factors boosting the demand side of the economy are only important insofar as GDP is below its potential level, meaning there’s still slack in the economy, or an “output gap.” We think there’s a good chance the output gap will be closed by 2022.

Increasing Our 2021 Inflation Forecast

Market-implied inflation expectations have soared in recent months. The five-year break-even inflation rate has surged, reaching 2.55% as of mid-April.

Also, heightened inflation expectations have finally begun playing out in the consumer price data, particularly for March. While the total Consumer Price Index had been increasing for several months on the back of recovering energy prices, core CPI growth was fairly muted until posting 0.3% month-over-month growth in March. Somewhat surprisingly, the uptick was driven by consumer services, despite the breakneck pace of consumer goods demand.

We still think that these growing pricing pressures reflect largely transient factors. While extraordinary demand for goods may generate pricing pressure in coming months, the eventual shift of consumer demand from goods to services should serve as a relief valve. Also, while the rapid rehiring underway in the services sector could induce wage inflation, this could moderate once unemployment benefits expire later in 2021.

With that said, our increased forecast for 2021 GDP growth will translate into higher inflation in 2021 than we originally expected. We now expect inflation (as measured by growth in the Personal Consumption Expenditures Price Index) of 2.3% in 2021 versus 1.8% previously.

Overall, we forecast a 2.2% average PCE inflation rate over the next five years. This is roughly in line with the expectations implied by the 2.55% five-year break-even rate, as the latter is based on the CPI, which historically has grown 20-50 basis points faster than the PCE Index on an annual basis. The closing of the output gap could occur as soon as 2022 and will exert consistent upward pressure on prices.

While the Federal Reserve is likely to let inflation run slightly above its 2% long-run target over the next few years, this is consistent with its new average inflation targeting program. We think the Fed will have little trouble taming inflation before it gets out of control.