Former Treasury Secretary Larry Summers recently pointed out that overstimulation risk 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.
Summers noted the Biden relief package will inject around $150 billion per month. The CBO says the monthly gap between actual and potential GDP is now around $50 billion, and it will decline to $20 billion a month by year-end. (This assumes the COVID-19 virus and all its variants will be under control.)
If correct, that would mean 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.
My friend David Rosenberg says 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.
Others share Summers’ concerns and add more to the list. Former N.Y. 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.
- 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.
- 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. And some Fed economists and academics think it can run significantly higher, 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. More recently, 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.
- 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, but they might have to reverse course quickly if it starts getting out of hand. That, in turn, could set off market fireworks.
This all assumes that we emerge 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.
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