By Lloyd B. Thomas
Recently, we have heard increasing talk of a possible “blue wave,” in which the Democrats win control of the White House, the Senate, and the House of Representatives next week. What would be the consequences for U.S. financial markets and overall economic activity in the next four years if this happens?
First, consider the outlook for interest rates. In response to the pandemic, the Federal Reserve slashed the rate on 90-day Treasury securities from 1.5 percent to around 0.10 percent in March, where the rate remains today. Rates paid on savings accounts have thus been negligible. Long-term Treasury bond rates have fallen from an already-low level in March to near all-time lows today.
For example, the 10-year and 30-year Treasury bond yields have averaged about 0.75 percent and 1.5 percent since March, a small fraction of their normal levels. The Federal Reserve has pushed these rates as low as possible, mainly by aggressively purchasing long-term bonds in the market.
A blue wave would quickly lead to massive fiscal stimulus in the form of increased federal government expenditures as the Democrats try to jolt the economy out of its funk. This stimulus would come principally in the form of increased aid to individuals and businesses seriously impaired during the pandemic, aid to financially impaired state and local governments prohibited from deficit spending, and a much-needed major infrastructure program.
The increase in the federal budget deficit and its impact on economic activity will be large, tempered somewhat by higher taxes on individuals earning more than $400,000 annually along with a hike in the corporate income tax rate. This rate was slashed from 35 percent to 21 percent in 2017 legislation.
This massive fiscal stimulus would appreciably boost economic growth in the near term and hasten the decline in the nation’s unemployment rate. For the first time in many years, the nation’s inflation rate will likely exceed the Federal Reserve’s desired rate of 2 percent per year.
We could be witnessing annual inflation in the range of 3-5 percent by 2023 or 2024, along with more rapid wage growth. The Fed appears willing to live with inflation of that magnitude for a few years to compensate for chronically low inflation in the past 12 years. While inflation has adverse consequences for long-term growth, it reduces the burden of debt, which has increased rapidly in recent years, both in the public and private sectors of the U.S. economy.
Higher expected inflation and stronger economic activity work to boost long-term interest rates. Hence, it is almost certain that these rates will increase in the next few years. The 40-year bull market in bond prices will come to an end. Long-term bonds purchased now will prove to be a very poor investment. Mortgage rates will increase significantly, working to slow the recent boom in housing construction.
It will be essential for the U.S. Treasury to quickly convert as much of the national debt as possible from short-term to long-term bonds. This would lock in favorable borrowing costs for years to come, a move that will look very wise a few years from now. Otherwise, we could end up spending 5 percent of GDP each year just to service the national debt, which has doubled in the past 10 years.
For many investors, bonds and stocks are viewed as substitutes for one another. In the super-low interest rate environment of the past 12 years, investors have flocked into stocks in search of more attractive returns. The average dividend yield from stocks has been twice as high as the 10-year Treasury bond yield this year. This unusual phenomenon will come to an end as bond yields increase.
The ratio of stock prices to annual corporate profits per share has been exceptionally high in the past decade relative to historical norms, suggesting that stocks recently have been overvalued. Going forward, higher bond yields portend lower price/earnings ratios for stocks as investors find bonds increasingly attractive vis a vis stocks. Rates of returns from stocks are likely to be significantly lower in the next 10 years than in recent decades.
In addition to a stronger economy and lower unemployment, a silver lining in a blue wave is that inequality of income and wealth, boosted sharply in recent years, will likely be reduced. This will result from a sharp increase in the minimum wage, increased progressivity of the federal tax system, better health care and increased opportunities for lower-income individuals, and other forces.
Perhaps most importantly, the Trump administration’s disastrous laissez-faire approach to the COVID-19 crisis will immediately be replaced with an aggressive, science-based policy aimed at bringing the pandemic under control. This will enable us to return more quickly to pre-pandemic economic conditions.
Lloyd B. Thomas is an MU adjunct professor of economics.