25 February 2021 Macro Picture BOILING POINT Dario Perkins Market concern about “overheating” looks misplaced. In fact, running economies “hot” – for the first time in a generation – could bring huge benefits. The policy should boost supply potential (as in times of war) and create new policy space in the fight against deflation. There are risks to financial markets, conditioned to zero interest rates, but the alternative is worse – a large bubble. Chart 1: Now is the time to experiment with “high-pressure” economics 0.2 rolling 30-year US Phillips curve coefficient* 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.2 -1.4 -1.6 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 Source: TS Lombard estimates, *change in inflation that comes from 1%pts increase in unemployment OVER STIMULATED There is growing concern about “overheating”, particularly in the US. President Biden will pass another large stimulus, while the end of the pandemic should unlock powerful pent-up demand. Yet it will take more than a brief period of US economic resurgence to generate sustained inflation – especially as the demand boost is front-loaded and the world lacks secular catalysts. SUPPLY RESPONSE Inflation-worriers are not only underestimating the amount of slack in the economy, but also the potential for a “high-pressure” environment to lift supply capacity. Central banks are certainly keen to “run the economy hot” because it would also buy them insurance against deflation risk, creating new policy space. We review the evidence for positive hysteresis, esp. during WW2. HEAT DANGERS Now is not the time to bet against the reflation trade, especially with vaccines yet to take effect. Prices could spike temporarily higher on “reopening”, even if there is no danger of a sustained inflation outbreak. While central banks will remain extremely dovish, any inflation scare is still a risk to financial markets, conditioned to permazero rates. But the alternative is worse – bubbles! 欄 Book a video meeting with our analysts here BOILING POINT Inflation anxiety has been a recurring theme since the start of the COVID-19 crisis, which is not surprising given the nature of the shock and the massive policy response. These worries have increased again recently, fueling another selloff in bond markets. While there has long been a particularly noisy “policy-is-doing-too-much” brigade, they have now recruited some unlikely protagonists, including Larry Summers and Olivier Blanchard. Both economists were demanding massive fiscal stimulus before the pandemic, but are now worried that the budgetary response is becoming too large, especially in the United States. President Biden is pushing for another big stimulus programme, the second since the elections. Summers and Blanchard join a significant minority of investors who believe this fiscal support has arrived at a point in the pandemic where it is no longer needed, risking “overheating” and a sustained inflation problem. While there is an element of truth to this narrative – with COVID-19 vaccines set to unleash a vigorous economic recovery in 2021-22 – we think the warnings about sustained inflation are overdone. US fiscal stimulus/pent-up demand will fade relatively quickly, while the authorities in other jurisdictions are doing far less to support their economies. The world lacks a secular inflation catalyst. The economists who are worried about overheating base their inflation forecasts on a rather deterministic view of supply potential, rooted in flawed “output gap” measures. There are good reasons to think this approach has systematically underestimated the economy’s capacity, which could mean – even with further stimulus – most economies will not run into genuine capacity constraints anytime soon. Moreover, “running the economy hot”, which is something the authorities have generally avoided since the 1980s, might also elicit a supply improvement, through a process of ‘positive hysteresis’. There is certainly room to boost productivity, after a decade of inexplicable weakness, and to raise overall employment rates, especially in countries were participation has been declining (including the US). We also look at evidence from the Second World War, when a “hot” economy absorbed massive military expenditure without “crowding out” private activity. Sure, WW2 was associated with bursts of inflation, but these were mainly the result of specific machine shortages, rather than broad-based capacity pressures. Central banks are keen to repeat the “high-pressure economy” experiment today, with officials hoping this will provide extra protection against the lower policy bound (by raising r*). But they will need sustained expansion – not just a temporary fiscal boost – to realize their objective. What are the risks associated with running the economy “hot”? In contrast to the situation a decade ago, today the discussion is centered on the prospects for inflation, not the fear of the imaginary bond vigilantes or the risk of the public sector “crowding out” private-investment. This is an important victory for MMT, which has successfully moved the parameters of the debate. Nevertheless, there is no shortage of pundits who think inflation could quickly spiral out of control, with some even trying to resurrect the spectre of hyperinflation. Their analysis is clearly wrong – it not only misdiagnoses the causes of extreme inflation episodes (for which we offer a brief reminder) but it also forgets that central banks have retained their independence and are contemplating only a relatively minor overshoot. The monetary authorities have plenty of policy ammunition to deal with an inflation outbreak, if needed. In fact, the more serious risk from a high-pressure economy is what it might mean for financial markets, with asset prices increasingly conditioned to the prospect of permazero interest rates. While central banks will do their best to support financial conditions by staying dovish and downplaying the risk of inflation, they might not be averse to a further rise in bond yields, unless it causes wider turbulence (which they would certainly respond to). But a lot of frothiness now in asset prices, a high-pressure economy might ultimately provide a healthier macro environment for financial markets too. Macro Picture | 25 February 2021 欄 Book a video meeting with our analysts here 2 1. OVER STIMULATED The debate about inflation, which has featured prominently in our discussions with investors over the past year, is becoming increasingly intense. This is partly a disagreement about the nature of the economic crisis. Is it a mainly a contraction in supply, caused by government shutdowns, or is it mainly a demand shock? (It is both…) Will the crisis fade quickly like a natural disaster, or linger with permanent macro scarring? And then there is the debate about the policy response. Since the start of the pandemic, there have always been some investors who felt the policy stimulus would eventually become too large, causing the world economy to “overheat”. Oddly, the policy-is-doing-too-much brigade have recruited some unlikely supporters, with Larry Summers and Olivier Blanchard – arch Keynesians – recently voicing their concerns about the magnitude of the stimulus effort in the US. The tipping point was President Biden’s latest spending proposals, which add to the massive fiscal programme Congress had already passed in December. The Summers/Blanchard opposition is noteworthy because both economists had previously been fiscal activists, arguing this was the appropriate response to secular stagnation. Chart 2: Too much US stimulus? Chart 3: The largest fiscal expansion ever 10.0 per cent of US GDP change in US fiscal position, per cent of GDP 8.0 S&L crisis 6.0 4.0 Dotcom 2.0 Great Depression 0.0 -2.0 Subprime -4.0 World War 2 -6.0 CBO End 2021 Next Biden Excess COVID-19 shortfall in stimulus personal 2020 saving -10.0 -5.0 0.0 Source: CB, TS Lombard Source: BEA, TS Lombard Overheating worries Concern about overheating is mainly centred on the size of President Biden’s budget easing relative to consensus estimates of the output gap. Congress looks set to approve tax and spending measures worth around 7% of GDP, in addition to the 4% of GDP relief programme it agreed after the US election. The CBO, meanwhile, estimates a US output gap of around 4% of GDP in 2020, which it thinks will shrink to around 2% in 2021, as the economy reopens. Some economists believe this fiscal easing is poorly targeted and arrives at a point in the pandemic where it is no longer needed, with vaccines set to unleash a wave of pent-up demand. In fact, given the swell of excess savings in the economy, there may already be an “overhang” of policy stimulus. By protecting people’s income during the pandemic and simultaneously restricting their spending opportunities, governments encouraged the build-up of a substantial stock of excess savings. When the pandemic ends, households might run down this buffer – the saving rate could even turn negative for a while – producing an extremely powerful economic boom. Unusually, we are in a situation where economists of entirely different persuasions seem to agree on the dangers of a sustained inflation outbreak. Keynesians, for example, are obsessed with the size of the US stimulus programme relative to some underlying measure of the output Macro Picture | 25 February 2021 欄 Book a video meeting with our analysts here 3 gap, while – at the other end of the economics spectrum – monetarists are worried about the unprecedented expansion in the money supply. The two developments are clearly related. By retaining their excess saving in highly liquid form, households and corporates have caused bank deposits to swell, producing a massive increase in the money supply. According to standard monetarist analysis, many households now hold a larger stock of liquid assets that they would normally desire, which they must eventually try to eliminate by spending more on good and services (or putting the cash into financial markets).