Overstimulation Risk
By John Mauldin
Among the many strange, unforeseen changes of the last year is a
new respect for Keynesian economic theory. Practically everyone in power now
agrees that deficit spending produces GDP growth. They differ only on its
expected magnitude and duration. The few exceptions are mostly outside the
halls of power.
This matters because deficit spending, already higher than ever,
is set to grow even more when Congress passes President Biden’s pandemic relief
package. I take it as given they will
pass it, since Democrats have the necessary votes and look united on the major
items. They may tweak some details to satisfy Manchin or Tester but the final
amount will be somewhere close to the desired $1.9 trillion.
Coming on top of trillions already authorized in prior bills, a budget deficit that was already approaching $2 trillion before the pandemic, and the Federal Reserve stimulating in its own ways, people are asking whether this is too much. The answer depends on the coronavirus “Gripping Hand.”
If the
vaccines work well enough, and are administered widely enough, to stop the new
variants and enable economic normalcy later this year, all that money might be
excessive. Rising consumer demand combined with supply constraints could spark
inflation.
If, however, the pandemic continues into summer, it will mean the
Gripping Hand is still squeezing us. Employment won’t recover and more small
businesses will fail. This relief package, as large as it is, may prove
necessary and maybe even too small.
The experts I trust are split on this question, and of course no
one really knows. But the debate is important philosophically. Nothing
underscores this more than the comment from my personal economic bête noire,
Modern Monetary Theory exponent Dr. Stephanie Kelton. Asked whether she was
worried about the stimulus bill causing inflation, she said:
"Do I think the proposed $1.9
trillion puts us at risk of demand-pull inflation? No. But at least we are
centering inflation risk and not talking about running out of money. The terms
of the debate have shifted."
This is precisely what should concern us. No one except a few old
classical economists is afraid of growing the debt. That argument is seemingly
over, and its absence may be the real story here.
Today I’ll explore where all this may lead.
The case for inflation
The concern we may overstimulate took off this month when former Treasury Secretary Larry Summers, a Democrat, pointed out that it will far exceed the “output gap” shown in the latest Congressional Budget Office economic projections.
What is an output gap?
Gross Domestic Product measures (or at least tries to) economic growth. Economists also calculate “potential GDP,” which is how much the economy could grow, if every available worker and other resource were fully employed. Inflation tends to occur when actual GDP exceeds potential GDP because the economy is “running hot.”
An output gap is when it goes the other way, with the
economy operating well below its potential. That’s what we see in recessions.
Of course, all this involves numerous assumptions. GDP itself has
problems, too, but it’s still a useful framework for analysis. Government and
central bank policy should aim to keep the economy running roughly in line with
its potential: not too hot, not too cold.
Larry Summers noted the Biden relief package will inject around
$150 billion per month, while CBO says the monthly gap between actual and
potential GDP is now around $50 billion, and will decline to $20 billion a
month by year-end (because it assumes the COVID-19 virus and all its variants
will be under control).
If correct, that would mean (at least to Summers and former
Senator Phil Gramm, who wrote almost simultaneously a similar editorial for The Wall Street Journal) we
are about to inject far more money than the economy can handle. It will have to
emerge somewhere and may do so as price inflation. Here’s Summers:
[W]hile there are enormous
uncertainties, there is a chance that macroeconomic stimulus on a scale closer
to World War II levels than normal recession levels will set off inflationary pressures
of a kind we have not seen in a generation, with consequences for the value of
the dollar and financial stability. This will be manageable if monetary and
fiscal policy can be rapidly adjusted to address the problem.
But given the commitments the Fed
has made, administration officials’ dismissal of even the possibility of
inflation, and the difficulties in mobilizing congressional support for tax
increases or spending cuts, there is the risk of inflation expectations rising
sharply. Stimulus measures of the magnitude contemplated are steps into the
unknown. For credibility, they need to be accompanied by clear statements that
the consequences will be monitored closely and, if necessary, there will be the
capacity and will to adjust policy quickly.
Others share Summers’ concern and add more to the list. Former New
York Fed President Bill Dudley wrote a Bloomberg column back in December titled
Five Reasons to Worry About Faster US Inflation. I’ll
summarize them for you:
- The way prices fell abruptly last April and May will
change the year-over-year comparisons this spring, making annual inflation
figures jump. (Note that if you go back two years to 2019 the inflation in
the annual number magically disappears.)
- As normal spending returns later this year, the leisure
and hospitality industry will regain pricing power. Sharp price increases
may be needed to balance demand with diminished supply. (The industry
dearly hopes so.)
- Companies won’t be able to meet increased demand by
simply producing more. Many expansion projects and investments were
suspended in the last year and some businesses have simply disappeared.
- The Fed recently revised its policy guidelines to allow
higher inflation. The target is now 2% average
inflation over some undefined period. Since it is presently below 2% and
has been for years, they’re saying it can run above 2% for a significant
time before they change policy. (And some Fed economists and academics
think it can run significantly high, with 3% or even 4% not scaring them.)
- Shifts in both political control and fiscal thinking mean the government is now more likely to spend aggressively, and less likely to remove stimulus quickly.
Again, that was Dudley talking two months ago. All still true now.
But this week he added Four More Reasons to Worry About US Inflation.
- Economic slumps brought on by pandemics tend to end
faster than those caused by financial crises.
- Thanks to rescue packages and a strong stock market,
household finances are in far better shape now than they were after the
2008 crisis.
- Companies have plenty of cash to spend, and access to
more at low interest rates.
- Inflation expectations are rising, which can lead to
actual inflation.
Dudley notes the Fed’s latest projections foresee no rate hikes
through 2023. This suggests they won’t be quick to tighten if inflation
appears, and might have to reverse course quickly if it starts getting out of
hand (though I am not sure what “out of hand” actually means today). That, in
turn, could set off market fireworks.
Again, all this is premised on emerging from the pandemic. I think
Summers and Dudley will both agree inflation is the least of our worries if the
pandemic is still raging next fall. We have reasons for optimism but this is
hard to predict—which is why we have to consider all the risks.
No Worries?
Not everyone fears inflation. Dave Rosenberg’s economic forecasts
have been right on target over the last year, and he sees little inflation
threat. In one of his morning letters last week, Dave ran through the global
vaccination rates and production bottlenecks. Noting the stock market has
priced in July as the month when we put the pandemic behind us, he calls that
expectation “fanciful.” But more to the point, he doesn’t think the stimulus
package will stimulate much.
The stimulus checks are coming. The
Fed is not going to be doing anything but buying assets and pressing the funds
rate to the floor. Inflation is already being widely advertised and priced into
bonds. And the fact that the markets shrug off bad data means that the incoming
economic information will be treated positively if the numbers are good and
dismissed as old news if they are bad. That is how the markets have been
positioned since the election and even more so after the Georgia Senate
run-offs. And so it is.
We have till July to see how all
this plays out. The market is betting that the stimulus will lead to huge
spending and not saving, that the economy reopens for good in July, and that
the next source of optimism will come from the “infrastructure spend.”
From my lens: That $1.9 trillion
will end up being more like $160–$180 billion once (i) debt paydown, (ii)
bumped up savings, (iii) rent, utilities, health care bills and (iv) import
leakage are accounted for
The timeline for herd immunity and full reopening is November, not July, and even then, the absence of this for the entire world means international travel and tourism will remain impaired. The US economy has high domestic content, indeed, but tourism in particular is a huge contributor to the retail/leisure/hospitality industry. Ask any Broadway theater owner in Manhattan about that.
Later in the week, in reacting to weak inflation data from China,
Dave said it again.
China’s YoY inflation rate swung
back to -0.3% in January from +0.2% in December (consensus was 0.0% so a
downside surprise); the non-food index also deflated at a -0.8% YoY pace from
0.0% (the PPI was +0.3%, which was in line with the consensus view—that’s all
you get with this commodity boom?).
So the world’s strongest economy is deflating and everyone believes the US is on the verge of a new inflationary experience because of temporary, if large, “stimulus checks”—this isn’t actually real stimulus, it is charity, and less than 30% of it finds its way into the economy and all it does is ensure that rent payments, utilities and food bills get paid. The “New Deal,” this is not.
Dave is saying the idea that stimulus will exceed the output gap is wrong.
His numbers suggest most of the $1.9 trillion will go into debt paydown, savings, or non-discretionary spending like rent.
That would leave
little for the kind of new spending (travel, entertainment, services, etc.)
that would stretch capacity and spark inflation.
To use more technical terms, Dave is saying the “fiscal multiplier” of this spending will be pretty low.
Lacy Hunt says the same. In a phone call Tuesday, he told me these sort of debt-financed stimulus programs provide only a short (a quarter or two), transitory GDP boost.
He rattled off
numerous examples from Japan, Europe, and here in the US. The 2018 tax cuts,
for instance, pushed GDP above potential for a little while but by 2019 the
effect had largely faded.
Worse, Lacy has found these programs actually have a negative multiplier once the effects play out over a few years. The new debt issued to pay for them weighs on growth, the velocity of money falls further, and the economy is worse than ever. Raising taxes wouldn’t help, either. Both taxes and government debt divert money out of the private sector.
Necessary Conditions
Let’s pull all these pieces together.
For inflation to be a near-term threat, several things would have to happen this year:
- Vaccines and other measures bring the pandemic under
control this summer
in the US and other developed countries
- Consumers respond by using their government benefits,
savings, and/or borrowing to quickly
increase spending on discretionary goods and services.
- This spending is sufficiently large to exceed
post-pandemic production capacity, sparking price increases.
- The Federal Reserve lets the economy “run hot” and
maintains its low rates and asset purchases.
- Congress and the Biden administration leave the fiscal spigots open by not raising taxes or cutting spending.
All these are possible. Are they likely?
One certainly is: I think the Fed will stay loose in almost any possible scenario, just as it did long after the last recession ended.
The
FOMC members don’t have the stomachs for another taper tantrum, much less the
explosive reaction aggressive tightening would produce.
But the others are much harder to predict.
The more we learn about the B117 and other variants, the more likely another viral surge looks. But it may be more manageable if we’ve vaccinated enough older and vulnerable people, and if the vaccines are as effective against variants.
As I’ve said for the last four weeks, it is a true race.
The US is now administering over 1.5
million vaccinations a day and the number is growing. By the time many of you
will be reading this letter, they should have reached slightly over 15% of the
population, and a much higher percentage of the vulnerable population.
If we faced only the original virus, we could actually begin to relax. Those cases are clearly dropping. But US government officials, looking at the same B117 growth rate that I am, and also the South African and Brazilian variants, are reportedly considering internal US travel restrictions to slow potential outbreaks.
I applaud them for not being complacent. But if
any travel restrictions are enacted, you can stick a fork in inflation Any
worries about it will be over.
It’s also hard to project how much consumer spending patterns will
change, and how quickly. Even if the pandemic fear fades, people can only take
so many vacations and get so many haircuts. This “pent-up demand” we hear about
doesn’t apply to services the same way it does to goods, and services have
suffered the most.
People are being cautious. Prior stimulus checks helped pay down
debt and add to savings. Another wave of the virus will make everyone even
slower to spend. That wouldn’t be inflationary.
It also matters, for both goods and services, how post-pandemic demand matches post-pandemic supply. Businesses may or may not be ready to deliver exactly what consumers want to buy.
Further, when 150,000+ small
businesses have closed, there may be a lot of missing supply. We should expect
shortages of some things and surpluses of others. How all that will sort out,
and its effect on prices and therefore inflation, is unclear.
It won’t help if the Democrats raise corporate or high-earner taxes, as Biden promised, but I’m not sure their slim majorities can do it, even if they blow up the filibuster. The size of the fiscal relief package is certainly an issue, as well as how it works. Different components will have different effects.
Fed Chair Jerome Powell: We Need More Stimulus and Inflation Is Not a Worry
The heading says it all, which is a six-inch summary of a long speech and question-and-answer session this week in New York.
My friend David Bahnsen summarized it this way:
I… want to share more about Chairman Powell’s speech to the Economic Club of New York after I got to dive into it deeper last night.
It is impossible to interpret really any part of the speech as anything other than hyper-dovish.
All “talking up” was about the need
to improve labor market conditions, and all “talking down” was concerns about
inflation.
…Ultimately, what the Fed has to do is message a concern about the gap between current unemployment and pre-pandemic unemployment, as observers and actors note the significant reduction in the unemployment rolls since the pandemic began.
It is this gap
the Fed is talking about (circled in blue below), and rather than talk about
“finishing this gap off” (getting down from 6.7% to 4%, for example), the Fed
is actually talking about how even the drop from 14% to below 7% is not as good
as it looks, because of the 2% decline in the labor participation force.
Source: David Bahnsen
I agree with Jerome Powell that the unemployment rate is clearly understated. I know many readers have a problem with the Labor Department’s business birth/death estimates.
Of course it is aspirational. You can’t know
the real number for at least a year, so they make the best estimate they can.
However, the “past performance” data the estimates are based on is clearly
broken when 150,000 (if not more) businesses close in less than a year. Using
that estimate forces the unemployment rate artificially lower. Their models no
longer apply to the world we live in.
My friend Philippa Dunne in the latest TLR describes an alternative survey by researchers working with the Dallas Fed.
It pegs the January unemployment rate at 11.4%, vs. the 6.3% official number.
I’ll bet you a dollar to 40 doughnuts Powell is looking
at that model or something like it.
Add all this together and inflation is a risk, but I don’t see it as a major one.
An output gap combined with above-10% unemployment is not the stuff inflation is made of.
Yes, the latest spending plan could temporarily
raise the relatively benign inflation we see today, but it will be transitory.
And if inflation does jump?
It would mean we’re done with the virus.
That might not be such a bad trade-off.
What’s in Your Investment Kitchen?
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And I’ll be making a few calls myself to get a feel for what it is that you are really thinking about, what’s important to you, and what you need. So don’t be surprised if you get a call from me.
Puerto Rico, New York?, and Maine
We’ve had a lot of rain here in Puerto Rico. Everything is green.
My mainland friends talk of snow and ice. I don’t miss that.
I still have not gotten my vaccination, although hopefully next week.
A month or so after the second shot, I really would like to get to New York for
business reasons, and of course to meet with friends. I just don’t know when
that will be.
Then I have (perhaps optimistically) made a reservation for my son
Trey and I to go to Maine in August for our (until last year) annual fishing
trip. I hope not to postpone it again. I really do miss the friends and
comradery.
I really look forward to talking with a few of you. I will learn
something and it will be a lot of fun. With that, let me wish you a great week
and hit the send button. Stay safe!
Your running as fast as I can analyst,
|
John
Mauldin |
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