Will we finally see inflation & overheating after the $1.9tr fiscal package?
The Fed doesn't plan to tighten policy until 2023, but Yellen says we'll be back to pre-Covid employment level by end of 2021 if the $1.9tr package passes, which may force Fed to tighten earlier...
I haven’t really been able to send emails this past week because life is a bit hectic for me at the moment. I’m working on some longer pieces about Clubhouse and the great technological stagnation amongst other topics. Hopefully they’ll be done soon.
One topic that I want to quickly address today is inflation expectation. My friend Will Carpenter and I have written a long three-part overview of inflation outlook, and back then one of our punchlines was: Inflation is determined by a basket of goods & services. Covid caused no signs of broad-based inflation. If you are worried about it, you have to point out where exactly it’s coming from.
Today the conversation has shifted quite a lot…
Look at the labor market for signs of inflation
Apollo Chief Economist Torsten Slok recently wrote in an email that “We have not seen the US economy overheat since the 1960s. Nevertheless, overheating has suddenly become a topic in markets.”
At the end of the day, when talking about whether we’ll have an overheating economy and subsequent inflation, we need to look at the labor market. The most recent employment report released in early February 2021 shows that our economy is still 10 million jobs lower than in February 2020. This menas that we would need to create 10 million jobs and bring the unemployment rate back to 3.5-4% before seeing an overheating economy and hence inflation.
Former NY Fed President Bill Dudley recently said that the labor market bounce-back could/will likely be much quicker than we expected if the vaccination proceeds smoothly.
Under The Fed’s current framework we won’t start tightening until 2023, but Janet Yellen is saying that we'll be back to pre-pandemic employment level by end of 2021 if the $1.9 trillion package goes through, which shows some great optimism.
If the economy gets back on its feet before the Fed’s current projections, that may force the Fed to start tightening earlier than expected, including reducing purchases of financial assets that are currently propping up the markets. If this happens, we may see a short rise in long-term interest rates and subsequently a correction of the stock market.
I previously wrote that the biggest threat to private equity funds might be a fast economic recovery because that would mean interest rates go up and the PE funds can’t finance their leveraged buyouts with cheap debt anymore. Well, that’s kinda true across the equity markets these days. A speedy recovery means an economic rebound, but that might not be the best news for financial markets per se.
The fears of overheating have been put into history books
The NYTimes did a piece yesterday titled “Biden and the Fed Leave 1970s Inflation Fears Behind.” The punchline is:
After years of dire inflation predictions that failed to pan out, the people who run fiscal and monetary policy in Washington have decided the risk of “overheating” the economy is much lower than the risk of failing to heat it up enough.
The punchline is the economic policymakers screwed up inflation forecasts so badly over the past few decades (constantly over-estimating) that they can’t keep justifying the concerns for it anymore. They don’t want to risk being too cautious because they can probably push the unemployment rate much lower than they thought before seeing any sign of inflation.
Inflation expectations vs. actual inflation rate
We should draw a distinction between inflation expectation and the actual inflation rate. Inflation expectation is what the markets think inflation may be; it matters because the actual inflation depends, in part, on what we expect it to be.
Inflation expectation is largely proxied by the spread between the 10-year Treasury yield and 10-year TIPS yield, and we call this the 10-year breakeven inflation rate. This rate has gone up 0.5% over the past year and is now at around 2.2%, which is not very far from the Fed’s 2% target for actual inflation. In short, the Fed has been repeating that they will do everything they can to get inflation up, and people find that credible, hence having actual expectations for it to go up.
The impact of fiscal stimulus depends on the composition
The real debate here is whether the $1.9trn fiscal stimulus package will overheat the economy and create a lot of inflation. Those who are opposed to the package would probably argue yes, but that is not necessarily true.
Torsten recently explained in his email that “one dollar spent on vaccine distribution and one dollar spent on stimulus checks will have different impacts on GDP. For example, the effect on GDP of a $1400 check sent to households will depend on the marginal propensity to consume for low, middle, and high-income households. Some households will use all $1400 on consumer spending, and other households will spend less. In other words, the impact on GDP of a $1.9trn fiscal package depends on the assumed fiscal multipliers of the different components of the package.”
This idea of marginal propensity to consume (MPC) is so crucial in determining economic policy. We all know that our consumption is not a constant fraction of wealth. For example, Jeff Bezos has increased his wealth by billions during Covid, but he will not increase his consumption accordingly. Therefore, the poor often have a higher MPC than the rich because they need to spend that money in the real economy more urgently rather than saving it or investing it in the stock market. Therefore, giving a stimulus check to a rich person doesn’t yield as much stimulating effect on the economy as giving the $1400 to a poor person, who would really use that money.
So, when we talk about the effect of the $1.9 trillion package, we have to look into its actual composition and see if the money is indeed going to parts of the economy and people that need it the most. If not, then we probably won’t see rising consumer prices; and even if we do, the shock will likely be temporary.
Fed Chair Powell has been pushing back on the idea that the economy is at risk of overheating for a while, and I wrote about this following his 1/14 press conference exactly a month ago:
Q: In the debate of whether we will see inflation soon: we see Japan experiencing huge deflationary pressure, but some also worry about pent-up demand suddenly pushing up inflation. Will we be in either of the two extremes in America?
Powell: A one-time increase in price doesn’t lead to persistent high inflation because of the underlying dynamic in U.S. economy. We have a flat Phillips Curve now, meaning there is low persistence of inflation. Inflation doesn’t stay up, unlike back in the hyperinflation era in the 1970s, when there was a very steep Phillips Curve.
We also have a slack labor market, so inflation won’t come up anytime soon. If inflation were to move up in ways unwelcomed, the Fed will surely use tools to push it down. It’s the persistent low inflation that is more worrying.
If you want to learn more about inflation expectations and the cyclical vs. secular forces driving inflation today, this is a great short interview to watch by Dallas Fed President Robert Kaplan:
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