As the latest COVID-19 relief bill winds through the U.S. Congress, some economists have been warning that too much stimulus could lead to the economy overheating. These economists have even alluded to rising risks that inflation returns to levels not seen since the 1970s, which could force the Federal Reserve to hike rates much sooner than many expect – perhaps as early as next year.

However, we believe the practical risks of a 1970s-style inflationary episode are relatively low even if the size of spending is large compared with the current size of the output gap. Structural changes in the U.S. economy over the past 50 years, most notably lower labor bargaining power, have reduced the likelihood that history repeats itself. (For details, see our recent blog post on U.S. fiscal policy and inflation risk.) Our view is also consistent with the recent price action in bond markets. While real yields have moved higher – likely driven by an improved growth outlook and additional expected fiscal stimulus – longer-tenor breakeven inflation spreads are pointing toward inflation at the Fed’s longer-run target, not suggesting a worrisome rise in inflation expectations.

Yet that is not to say that we do not see other risks to the U.S. recovery. We would argue that financial stability risks could rise further. With an estimated $1.1 trillion in excess savings currently sitting in checking and savings accounts, it is possible that some of that money finds its way into financial markets, further stretching valuations. This, compounded with other concerns, reinforces our view that macroprudential policies will likely tighten over the next few years. To ameliorate these risks, the Fed would likely only raise rates as a last resort. Nonetheless, the bigger point is that being overly focused on inflation concerns may miss issues around financial stability that have a greater likelihood of affecting markets.

The output gap and savings

According to PIMCO’s estimates, which incorporate our view that the fiscal multipliers will be more muted due to pandemic-related restrictions, we expect the U.S. output gap to close by year-end, and for output to exceed potential modestly in 2022. This forecast suggests we could see a return of a roughly 3.5% unemployment rate, which we think will be offset to some extent by labor supply improvements as individuals who dropped out of the labor market return, and is consistent with some moderate above-target inflation.

Embedded in our output gap forecast is also the assumption that consumers won’t spend the brunt of their excess savings, at least not right away. The cumulative excess savings, based on National Income and Product Accounts (NIPA) measurement, is around $1.6 trillion, and the Fed’s Financial Accounts suggest that most of that money is currently sitting in checking and savings deposits. These estimates of excess savings don’t account for unpaid mortgage principal from forbearance, which Black Knight estimates to be worth around $500 billion. Nonetheless, adjusting for that, excess savings of $1.1 trillion is still large.