Will Stimulus Spark Inflation? Two Shocking Theories You Should Know

This is Part 2 in our attempt to answer today’s most debated question: Will stimulus cause inflation?

I can tell you, this is a beast of a topic. I’ve sifted through hundreds of pages of internal reports from top Wall Street banks and parsed dozens of columns from the world’s leading economists. And if there is one thing I learned, it’s that a case can be made for either scenario.

Last week, I talked about why inflation fears didn’t come to pass after 2008. (Read Part 1 here.) Today, I’ll discuss why trillions of “printed” dollars during Covid haven’t brought back inflation—and two arguments (for and against) post-Covid inflation.

Let’s get to it.

Where’s inflation?

Since the onset of Covid, Uncle Sam has poured more than $5 trillion (and counting) into the economy. The flood of money was so immense that it did more than save the “grounded” economy. In one of history’s biggest economic shocks, it made Americans—at least in dollar terms—richer than ever.

Despite that, inflation has barely budged—which shouldn’t be surprising at this point.

As we discussed last week, there’s no connection between money creation and inflation. For proof, here’s a chart that plots money supply and inflation over the past 50 years:

Second, falling prices are a common side effect of recession. That happens for a few reasons:

  • Lower wages. Businesses lay off employees, which leads to higher unemployment and competition. That makes it harder for workers to bargain for higher wages.
  • Lower commodity prices. Recession brings down business activity, which reduces the demand and price for oil and other commodities. And the price of commodities is one of the biggest drivers of inflation.
  • Lower spending. People and businesses become less confident in an economy. They save more and spend less, which eats into demand.
  • Lower prices. The end result is that businesses end up with stockpiles of inventory. To stay afloat, they sell out at a discount.

Covid makes things even worse. Today most people can’t physically spend their money even if they want to. The result is that a big chunk of Uncle Sam’s “windfall” didn’t make it to the economy. Instead, it’s socked away in savings accounts:

That means the most important question is not why we don’t have inflation, but whether we will when life gets back to normal? And there are two sides of the debate.

The case for post-Covid inflation

Remember the inflation definition from last week? “Too much money chasing too few goods.” One way to tally that up in a multi-trillion-dollar economy is to use a measure called “the output gap.”

In short, it tells you the difference between what the economy is producing (GDP) versus what it could potentially produce (potential output). The latter is the “ceiling” on goods and services an economy can efficiently turn out at full capacity.

A positive output gap is when the economy is making more stuff than it’s supposed to. It often happens when demand blows up. To meet that demand, the economy cranks out stuff in a lousy way (e.g., it rushes to hire people who may be incompetent and too expensive). That adds to costs and creates inflation.

The opposite is a negative output gap. It happens when there’s not enough demand to consume all the stuff the economy could potentially produce. This shortfall in demand leads to falling prices.

All this theory brings me to the case for post-Covid inflation.

Former Treasury Secretary Larry Summers thinks the trillions of dollars Uncle Sam is shoving into the economy will lead to a huge positive output gap. In other words, stimulus money won’t just fill up the void, it will build up a stack of cash on top of it.

In a recent Washington Post column, he wrote:

“[After the $900 billion stimulus] the gap between actual and potential output will decline from about $50 billion a month at the beginning of the year to $20 billion a month at its end. The proposed stimulus [$1.9 trillion, already passed] will total in the neighborhood of $150 billion a month, even before consideration of any follow-on measures. That is at least three times the size of the output shortfall.”

Let’s put that in perspective.

In the 2008 financial crisis, Obama passed an $800 billion stimulus package. By Summers’s calculations, that stimulus amounted to just half of the shortfall in the output gap. Meanwhile, the most recent stimulus today is 3-6X the estimated “slack” in the economy.

Here’s what that looks like:

For those reasons, Larry Summers and a handful of other Fed critics believe Covid’s stimulus creates the highest inflation risk in 40 years.

The case against post-Covid inflation

Others think that “inflation doomsayers” are laying it on  too thick. That camp includes the Fed (obviously) and the International Monetary Fund—as well as economists from Goldman Sachs
GS
, UBS, JPMorgan
JPM
, and many others.

Their key argument is that trillions of “printed” dollars don’t automatically translate to economic output. And that has to do with a less-known economic term called the “multiplier effect.”

In a human language, it measures how many dollars a dollar in government spending generates. For example, at a multiplier of 0.5, the government creates half a dollar for a dollar spent. Think of it as “return on investment” for government spending.

So the catch is that the “doomsayers” use the average multiplier from a 2014 report, which is around 1.2. That means they expect stimulus money to generate more economic output than the injected cash itself.

But that may be wrong.

The Congressional Budget Office (CBO) recently reported that Covid has brought down the multiplier because a big chunk of money simply can’t be spent. And even after Covid, it may stay lower than usual. A number of surveys suggest people may choose to save that money, not spend.

For this reason, UBS economists estimate that over $2 trillion in stimulus this year will generate no more than $1 trillion in GDP. By their calculations, that will create a little positive output gap this year and the next—which would translate to a mild inflation of 1.8%.

In a picture, it looks like this

The best investments to fight inflation—from mild to extreme

I’ve warned you—there would be no simple answer. But at the very least, I hope I’ve given you enough food for thought to help you pick your side of the debate. And depending on where you stand on it, here are some investments to look into.

For starters, here’s a handy breakdown from JPMorgan with the best inflation hedges in three inflation regimes (0-3%, 3-6%, and >6%):

There’s one catch here. Historical data doesn’t necessarily mean that these investments are selling at a bargain right now. Considering today’s valuations, JPMorgan strategists suggest these investments.

For beginner investors:

  • Oil and energy stocks. You can pick specific stocks or invest in an ETF that tracks a broad basket of stocks, such as Vanguard Energy ETF (VDE)
    VDE
  • TIPS. These are inflation-protected government bonds whose value and interest payments adjust based on inflation. In theory, they 100% protect your money from official inflation (CPI). The downside is that you don’t earn a thing on top.

For advanced investors:

  • A broad commodities index—and the agriculture sub-category in particular
  • Currencies of commodity-exporting countries (South African Rand, Russian Ruble, Brazilian Real)

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