Krugman vs Summers: Round 2?

The yield on the 10-year Note has risen 89% YTD as of 3/19 (from 92 bps to 173 bps) and 223% since a low of 54 bps back in July. Obviously % changes from such a low base are going to be dramatic. But it's got market analysts and economists somewhat freaked out about the "i" word.

To be sure, the rise in yields has tracked the progress of vaccines approvals and improvements in the economy...but has risen sharply in recent weeks as the Democracts successfully pushed through a massive $1.9 trillion stimulus. While Republicans predicatably blasted the deal, one of its harshest critics has been Larry Summers who believes the recently passed $1.9 trillion stimulus will "set the economy on fire." Err, that's economist speak for 'are you outta your f***ing minds?'

Last month we highlighted a fascinating discussion or "debate" between Paul Krugman and Summers concerning the yet-unpassed stimulus package. Essentially, both agreed that more support for the economy and, in particular, vulnerable groups was needed, but disagreed on the size of the package. Krugman wanted Biden to go big or risk a weak recovery, while Summers thought the size of proposed stimulus was overkill and risked stoking inflation, if passed.

Well, the stimulus did passed (surprisingly? shockingly?), giving the Democracts a huge political win. But what does it mean for inflation? Bloomberg's Wall Street Week invited both Krugman and Summers to make their points again this week: 

Krugman dismissed worries of 1970s-style inflation saying the latter did not transpire overnight, but took hold gradually over a decade of poor policies and oil shocks. His big argument continues to be that the bigger risk is not doing enough to support the economy. The fiscal stimulus had to be massive because with short-term interest rates near zero, stimulatory monetary policy options are limited. However, precisely because rates are so low the Fed has a lot more options should the economy heat up. And Krugman believes the Fed is up to the job of managing price stability. Period. So, he sees an asymmteric risk-reward here.

Summers, on the other hand, sounds even more critical than he did a few weeks ago, calling the stimulus package the "least responsible fiscal macroeconomic policy we've had for the last 40 years." Blaming the instransigent Democratic left and all Republicans. He was also pointedly critical of Krugman for bringing political analyses into what should be a rational economic discussion. We've covered all this previously. But what was surprising here was Summers' conviction that it would go all wrong; starkly warning that he thinks there is a 1/3 chance Fed will be behind the curve and we become an inflationary country, 1/3 chance the Fed surprises the markets, reacts hard and puts the economy in recession, and 1/3 chance that by some miracle he's wrong. 

So, I can see where Summers is coming from. Goldman Sachs and much of Wall Street is expecting 2021 GDP growth to about 8%, the fastest rate in 56 years! Unemployment at under 4% by end of 2021 and 2022 GDP growth at 4.5%! Whoa! Of course these are sell-side research forecasts which are always bullish ("...economy is growing, buy stocks!!" and Krugman has a wicked burn to just that point in the full version). But this chart from Blackstone does make that point, as does research from Summers and Furman. The BX graph (click to enlarge) shows the $2.2 trillion economic contraction Covid caused last year was largely (but not fully) offset by more than ~$3.5 trillion of federal aid even before the latest $2 trillion of stimulus. So, all this money is going juice growth and cause prices to rise, right?

Yes and no. The chart below shows the difference between nominal GDP and 10-year yields over the last 60 years. When the spread has been 5% or more, you've had a sharp rise in inflation (late '60s, '70s)...and based on analysts' forecasted 2021 GDP growth, the expected spread today is more than 6%!

Ergo, inflation? Summers is right?

...Not so fast. Analyses from the (leftish) Brooking Institution suggests growth will be transient. Their study projects the U.S. economy will experience moderate above trend growth in the short-term, 2H 2021 and 1H 2022, but revert back to pre-Covid trends by end of 2022. However, without the Biden package, Brookings estimates the economy would not fully recover for a long time...just like after the Great Recession. So Krugman "wins"...again!

What's more, the biggest boost to the economy will come from aid to financially vulnerable households. Yeah, this set of analyses defintely favors Krugman. Ding! Ding! Ding! 

But what about short-term inflation...how bad can it get? Meh, probably not that bad. The Fed's biggest problem the last three decades has been not enough inflation. Another $2 trillion won't make much of difference against the generational forces of an aging population, shrinking workforce, and deflationary technology as discussed previously. As for bonds...well those same forces will continue to ensure that private savings>private investments across the OECD and keep interest rates low.

I'll say this again. The best rebuttal to Summers comes from Summers, who very persuasively made the exact same argument when he famously revived the "secular stagnation" thesis. So, Treasuries at 1.73% may actually be a buying opportunity! I'm sure European and Japanese pensions will be thinking so.