What Causes Inflation?
At its most basic, inflation occurs when demand exceeds supply. Said differently, when too much money is chasing too few goods and services. From a policy perspective, demand can be increased through either monetary or fiscal stimulus. In a previous article I looked at whether the Fed’s quantitative easing program could drive inflation. My conclusion was that, in isolation, it wouldn’t be inflationary, though it is likely boosting financial assets (i.e., asset price inflation). Now I want to turn to fiscal stimulus and whether it could fuel inflation.
How Fiscal Stimulus Works
The basic idea behind fiscal stimulus is to take money that is sitting idle and put it in the hands of individuals who are more likely to spend it. The fiscal stimulus packages to date have been designed with the intention to restore income to those who temporarily lost their jobs due to the economic shutdown and thus help bridge the gap until their businesses re-open.
Too Much Stimulus?
The announced stimulus packages to-date, combined with the economic downturn, is forecast to add $3.3 trillion to the 2020 fiscal deficit (which was already on track to exceed $1 trillion). Fiscal stimulus of this magnitude has not been seen since World War II (WWII). Was it enough? In the just reported GDP for the second quarter, personal income increased 7% from the first quarter, which was the strongest quarter-over-quarter (Q/Q) increase in history. If we back out the contribution of government transfers to income, then income fell 6% Q/Q, which would be the worst decline in history. Consumer savings meanwhile increased by $3.1 trillion. This data suggests there was plenty of stimulus money to cover the income loss during the shutdown. But we have not vanquished the virus and the stimulus is running out. That suggests more stimulus is coming (without it, the near-term risk is deflation, not inflation). But given the magnitude of this stimulus, why doesn’t it feel like it was giant success?
Fiscal Stimulus Boosted Consumer Income and Savings in the 2Q While Spending Fell
(billions of dollars, seasonally adjusted at annual rates)
| Q1 2020 | Q2 2020 | Change $ | Change % | |
|---|---|---|---|---|
| Personal Income | 18,954 | 20,340 | 1,386 | 7% |
| Less government transfer receipts | 1,784 | 4,274 | 2,490 | 140% |
| Equals employee compensation and other income | 17,171 | 16,067 | -1,104 | -6% |
| Less: Taxes | 2,257 | 2.109 | -148 | -7% |
| Equals: Disposable Personal Income | 16,697 | 18,232 | 1,534 | 9% |
| Less: Personal Consumption | 15,103 | 13,538 | -1,566 | -10% |
| Equals: Savings | 1,594 | 4,694 | 3,100 | 194% |
"It Seems Scattershot" Jeremy Siegel
Fiscal stimulus is a blunt tool. Due to inefficiencies, it missed many who were in need as well as provided money to those who were not. Because of the uneven nature of the fiscal stimulus and the sustained impact on industries that require social contact, it has not prevented bankruptcies and business closures. Yelp, which publishes crowd-sourced business reviews, noted in its Economic Average report that as of July 10, “the percentage of permanent to temporary business closures is rising, with permanent closures now accounting for 55% of all closed businesses.”1 And should social distancing continue into the fall and winter (which seems likely), business closures seem likely to continue.
Could the supply reduction from these business closures eventually lead to higher prices? It is certainly possible, but the vast majority of business closures to date are composed of restaurants and retail stores. These businesses do have strong substitutes (take-out and eat at home for restaurants and ecommerce for retail) that are likely to keep a lid on their ability to raise prices. In addition, with capacity reduction comes more job losses that in turn will depress demand. These jobs tend to be low wage, which is one of the unique aspects of this downturn. There is inflationary risk from stimulus that went to savings, creating future spending fuel for when social distancing goes away.
Social Distancing Needs to Go Away
Social distancing could quickly go away with a vaccine that is widely available and effective. This would create the risk of consumer spending reigniting before supply gets rebuilt. Pent-up demand and excess savings from the stimulus could flood the economy with demand for goods and services, thereby putting upward pressure on prices. As strange as it is to say, that would suggest an effective vaccine holds the potential for hurting stocks and bonds. Inflationary conditions would put upward pressure on interest rates (leading to lower bond prices and price-to-earnings multiples), and would also remove the need for further monetary and fiscal stimulus (another important market driver). But in order for this to happen, investors would need to believe that the higher rate of inflation could be sustained for a long time.
Secular Versus Cyclical
The previous economic cycle which started in 2009 was the weakest expansion in terms of GDP growth since WWII. This was despite unprecedented monetary stimulus. And while the unemployment rate dove to levels that were well below the Fed’s estimate of full employment, it was not able to reach its inflation target of 2%. I believe this is due to a number of secular forces, that are global in nature, which have been putting downward pressure on inflation.
Many pundits believe that we are heading into an inflationary period like that experienced in the 1970s. These prognostications are based on the potential of a coordinated monetary and fiscal stimulus that continues into the future. In my next article I will explore this risk.
1 https://www.yelpeconomicaverage.com/yea-q2-2020
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