How Worrisome Is The Rise In Interest Rates?

The key to understanding the COVID-19 recession was in understanding that it was an exogenous shock. This made it quite different from your standard recession in the sense that a boom did not cause the bust. There was no endogenous build-up of unsustainable forces that led to the decline in output. COVID was much more akin to a natural disaster. This meant that the recession could be deep and painful, but it was unlikely to last very long. This was crucial to understanding (and a key component of my optimism last April) because it meant that the probability of a deflationary (or disinflationary) recovery was unlikely. For example, the 2008 recession was an inherent credit crisis. Credit expanded too much and when home prices collapsed that credit had to contract as well. Credit contractions are inherently long and drawn-out processes. Just as the build-up takes years to unfold so too does the contraction. COVID-19 was completely different. There was no credit event here as evidenced by total lending:

Credit contractions are inherently deflationary because they stifle balance sheet expansion which stifles aggregate demand. We need balance sheets to grow in order for the economy to grow. And boy did the government make sure that that happened, as they threw unprecedented levels of spending at the problem. As I said last April, this was extremely bullish because, unlike 2008, there was unlikely to be prolonged damage to key parts of the economy. This damage was much more acute and to the extent that it was permanent, it seems to be permanently impairing businesses that were likely to be impaired in the long-run anyhow (like commercial real estate, for instance). Going forward, the three big things that make this recovery so different from 2010 are:

  1. Output was mostly idled, but not destroyed. 
  2. Aggregate demand is likely to rebound much faster due to far larger stimulus.
  3. A series of supply-side constraints arising from all of the uncertainty of the pandemic will make it harder to meet that surging demand. 
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