It’s a hell of a balancing act and I admire the boldness of this initiative, as well as the general boldness of the Biden Team. I admit I am a fan. But there are things to know and risks to grasp, especially for people with funds in financial markets. At roughly 10% of GDP, Biden’s almost 2000 billion (2 trillion) stimulus package is massive. Obama’s package was roughly 5% of GDP in 2009. There are 2 views of inflation and stimulus packages, which are not necessarily mutually exclusive, but one places proportionally more weight on the “output gap” and “overheating”, the other puts proportionally more weight on inflation expectations and institutional credibility. Lets explore both angles…
Timing matters: Obama passed his stimulus package while the economy was still sinking and very deep in the hole in 2009, while Biden is passing his package in 2021, right after the Trump package of about 1 trillion just 2 months ago and is still having stimulative effects. Obama passed his stimulus while unemployment was high and rising, whereas Biden is passing his while unemployment is falling and not that high (although the employment rate is still very low). Is an inflation-and-interest-rate shock around the corner for 2021–2022?
Before exploring the inflation expectations / institutional credibility view, lets start with the “output gap” view of the world…
How much slack is in the economy?
Almost everyone agrees that the Congressional Budget Office estimates of “the outpug gap” is always too low, meaning that they systematically underestimate the “slack” in the economy. So how can we estimate the “slack in the system” other than by using the very blurry estimates of “potential” output? I like the following 2 variables, but I typically use these in combination with several others that capture cost pressures, labour market tightness, corporate activity, expectations, and more… but here are 2 usefull ones to capture the slack that is in the system now:
- The employment rate, which better captures the “slack” than the unemployment rate.
- Capacity utilization.
Considering that the US economy was “roughly at full potential” prior to the 2008 and 2020 shocks respectively, I take the previous peaks (prior to 2008 and to 2020) as proxies for the “full potential” measures, which would currently correspond to about this: 62% employment rate and 80% capacity utilization would correspond to “full potential”. We are currently at about 58% employment rate and 75% capacity utilization.
US Capacity Utilization:
Based on these measures, I estimate that the output gap was at least 10% in 2009 when Obama passed his stimulus package of about 1.5 trillion, (1500 billion) and the output gap is currently roughly 5% of GDP, or about 1 trillion dollars from full employment, which is MUCH bigger than the CBO estimate of about 2.5% below potential GDP.
Taking a “fiscal multiplier” of 1.5, we get the following:
Obama’s 800 billion stimulus of 2009 gave a total “hit” of 1.5*800 = 1200 billion. The output gap in 2009–2010 was about -1500 billion, hence Obama’s package was necessarily not inflationnary, as it “wasn’t big enough.”
Biden’s plan is 2000 billion, which should give a total hit of 1.5*2000 = 3000, or 3 trillion, with an output gap of only -1000 billion, hence the stimulus is considerably more than the output gap. This means that the Biden plan would at least theoretically bring the economy clearly in “overheating” territory.
The economy has “non linearities”: the aggregate supply curve is flat below potential and gets more vertical above potential. Hence the Obama package could never really be inflationnary. (Note: you can see this as the “Phillips Curve” is flat in a context of negative output gap).
Biden is passing a bill that is significantly bigger than the negative gap, which would bring the economy at LEAST in “overheat territory” by 2022–2023 and would theoretically be inflationnary, as the economy would run into the non linearities once close to potential (point B below), with the added issue of changing expectations and a growing poker game between the Fed and bond markets. (Note that the fiscal mutiplier is not constant: it is higher when GDP is below potential and lower when the economy is at or above potential).
So theoretically, we would get at LEAST a +1000 billion output gap by 2022, even (theoretically) +2000 billion. Hence something between +5% and +10% of potential GDP. A +5% positive output gap will NOT actually happen, much less +10%, because the economy would run into capacity constraints before that, and the pressure would be absorbed by prices instead.
Prices do not move much while below potential, but prices can start reacting once the economy is above potential, which means money stock growth matters once you are above potential.
Considering that money velocity plummeted in 2020 and is not likely to drop more during the 2021–2022 expansion, we can suppose velocity at best constant and look at the growth of M2 money stock, which still matters, especially once you are above potential.
Note that there is a bidirectional causality between money and prices: prices rise when past money expansion causes economic expansion, and the money stock expands due to higher money demand when prices rise due to a booming economy, so the direction of causality is not totally clear, but a “helicopter drop” of money IS indeed inflationnary… But helicopter drops never happen, right? Helicopters don’t fly around, dropping ballots of cash? Well, indeed, almost never. But the Biden plan IS largely a helicopter drop, as it sends direct payments to households, and that money will be largely spent due to pent-up demand after covid and the fact that low and middle-income households are tight on money and have urgent needs for spending. This is not rich people getting money who just stash all that in stocks and bonds.
M2 money stock year-on-year growth, 1960–2021:
Based on all of this, here are the cold facts:
- The US economy will likely enter “overheat territory” some time in 2022 or 2023 and expectations will start pricing all that in before it actually happens.
- A positive output gap combined to the huge monetary expansion and the FORM of the stimulus package (most of which is payments to people and businesses, which is indeed equivalent to a “helicopter drop” of money) could theoretically bring inflation to dangerous levels, potentially as high as 8% to 10%, thus necessarily bringing bond yields upward and causing a huge interest rate shock to markets and the real economy.
- The bond market is estimating all that I am saying now and is starting to price in an inflation shock for that same period of 2022–2023, which is brewing up some tension for the Fed, as I wrote in my last text “Central Banks vs Bond Markets.”
- Corporate debt and government debt are sky-high, stock and real estate valuations are sky-high, so an inflation shock that brings an interest rate shock would be nothing less than a catastrophy of epic proportions that could severely destabilize markets, the real economy, and social order, both in the USA and worldwide.
This is the “output gap” view of the world. Very competent and respectable economists see things this way, many of which are NOT “inflation hawks” at all. They do “admit” that inflation expectations and central bank credibility could keep a lid on inflation and perhaps keep it below 10% (lets say around 6%), but that is still a lot of inflation and could be enough to cause a nuclear detonation in bond markets, thus causing a massive shock to all markets, to the real economy, and to social stability down the road.
The inflation expectations and central bank credility view of the world says that inflation is kept in check by inflation expectations, which are kept in check by the central bank promise to ultimately keep inflation within reasonable levels, say below 3% or 4%. In this view, all that I have written above about overheating and the output gap and all that is to be heavily minimized in a macro context of low inflation for a dedcade and solid monetary credibility. Based on THAT view, inflation does not suddenly “jump” out of nowhere from 2% to 6%+. It remains within the bounds of “inflation expectations.” Here are 2 measures of inflation expectations now:
Survey of households:
University of Michigan survey of inflation expectations (blue) and actual inflation (red):
Based on this view of the world, there is nothing to call home about! Very competent and respectable economists say that this is a better proxy for inflation, hence that inflation fears are overblown.
The inflation-and-credibility view of the world tells us that inflation will remain in check, because inflation expectations are “well-anchored” due to solid credibility of the central bank. The Fed is indeed going out of its way to say that 1) whatever inflation happens will be modest and temporary and nothing to panic about, 2) that they have the tools and the will to contain inflation, and 3) that they also have the tools and will to keep long term interest rates in check (i.e. 10-year government bond yields!) with money creation-and-asset purchases and/or asset maturity rotation (“twist”), etc.
This “will and capacity to intervene” that is the foundation of everything staying in control may get tested going forward, as I explain in my last text “Central Banks vs Bond Markets.”
Who is correct: the output gap team or the inflation expectations team?
The “output gap” team says that they agree that expectations and credibility are the main drivers of inflation and interest rates, but what they fear is that the Biden package is so large that it will effectively bring the economy into actual inflationnary territory due to a positive output gap combined to huge money stock expansion in 2020 and 2021, thus bringing the economy to “capacity constraints” and actual inflation in 2022–2023, which would then create a “de-anchoring” of inflation expectations and hence a bond market selloff that the Fed would not be able to contain with maturity rotations only and would not be able to fight with money-creation-and-bond-purchases due to already-high inflation, as extra money would further dent the credibility of the inflation control promise. In short, this team says that inflation expectations will rise after actual inflation will rise due to an overheating economy in 2022–2023, and this will challenge monetary credibility and could become a very explosive mix.
The inflation expectations and central bank credibility team says that they agree that IF things go that far, THEN, yes, it would be a bad situation, but that things will NOT get to that point, that inflation expectations will remain anchored, that inflation is a slow process that the central bank can contain “as it starts happening”, and that inflation will at worst temporarily hit about 4% and come back down thereafter, without much negative consequences.
Who is right? We will know by late 2022 at the latest, and perhaps before. Stay tuned… Clap, share, and comment below!
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