Former U.S. Treasury Secretary Larry Summers has been the skunk at the fiscal stimulus picnic. He’s been vilified for saying the Biden administration’s $1.9 trillion stimulus plan was too large and will lead to higher inflation.
But Summers is right, a former Fed economist said Friday.
“The stimulus is five times bigger than any conceivable need,” said Joseph Gagnon, now a senior fellow at the Peterson Institute of International Economics.
“We’ve never done this since World War II and there was massive inflation. They put on price controls but there was still inflation,” he said.
The odd thing to Gagnon is that while so many economists are saying Summers is wrong, few are showing their math.
“The people who are saying ‘don’t worry about inflation’ don’t walk you through the numbers. They don’t explain why someone might think these numbers are scary,” he said.
Gagnon said that households have over $1.6 trillion in excess savings, with most sitting in bank accounts of people who never saved before. The stock market is at record highs, so wealthy Americans are also in the mood to spend. And vaccines are allowing the economy to reopen.
“We’re dumping two stimulus packages – worth 13% of GDP — on an economy that will be growing very rapidly, even without stimulus,” he said.
“We normally think that 2%-3% of GDP above potential is enough to generate inflation. What do we expect 13% to do?” he asked.
Adding to the concern, the U.S. is also about to record double-digit federal budget deficits for the first time since the World War II. And this doesn’t take into account any planned infrastructure spending.
“There are so many reasons to expect the mother of all booms in the next year,” Gagnon said.
Gagnon thinks that inflation, as measured by the personal consumption expenditure index, will rise to a 4% rate next year- well above the Fed’s forecast, and target, of 2%.
Alas, Summers shouldn’t plan a victory lap, Gagnon said.
The former Fed economists thinks the former Treasury Secretary is exaggerating when he says the economy is more likely to either overheat or end up in a recession than get through the price spike unscathed.
Gagnon said there are factors that will keep inflation from double-digit levels of World War II. Maybe people will save more than expected and state and local governments will set up rainy-day funds. So the stimulus might be closer to 6% of GDP.
If we get a surprise [on inflation] for a year, that doesn’t need to persist,” he said.
The Fed won’t repeat the mistake of being “clueless” about the inflation outlook as it was during the late 1960s, he said.
Back then, it took five years of Fed inaction to get inflation expectations unanchored, and for inflation to surge higher, he noted. It took former Fed Chairman Paul Volcker raising interest rates to 20% to combat inflation.
“I don’t think the Fed is going to allow that to happen this time. I just don’t,” Gagnon added.
Fed officials have said they have the tools to combat high inflation if it appears. But at the moment, high inflation doesn’t appear to be on the central bank’s radar. They have penciled in their first interest rate hike sometime after 2023.
The 10-year Treasury yield
TMUBMUSD10Y,
1.675%
has moved up to 4 basis points to 1.674% on Friday. Stocks
DJIA,
+0.55%
COMP,
-0.12%
have been choppy as investors weigh the risks of higher inflation.
