- Republicans argue that Biden’s stimulus plan will fuel rampant inflation. Wall Street is not so concerned.
- Big bank economists see the new aid raising inflation only modestly, while helping the US recovery.
- This is how UBS, BofA, Goldman Sachs and Deutsche Bank see the stimulus affecting inflation in 2021 and beyond.
- Visit the Business section of the Insider for more stories.
The debate over whether to approve President Joe Biden’s $ 1.9 trillion aid proposal is simple.
Democrats argue that the hole in the economy is so big that it justifies spending nearly $ 2 trillion, in addition to the $ 3 trillion spent last March and the $ 900 billion spent at the end of Trump’s term. Republicans point to all the relief the government has already provided and say the economy can recover with much less momentum. If you overdo it, they say, spending so much can take inflation to worrying levels.
But there is a third player in the debate: the Wall Street investment banks that are looking at math. And they are increasingly saying that concerns about rampant inflation are mistaken.
For weeks, economists at major banks stood aside, vaguely saying that another package would achieve its intended goal of accelerating growth. Now that Democrats are moving ahead with Biden’s large-scale plan and are likely to approve the bill in mid-March, the Wall Street assessment is unlikely to make Republicans very happy.
Each major bank has its own forecasts, models and team of experienced economists, and many are coming to the same conclusion: the benefits of the Biden plan overshadow the risks. After a decade of weak inflation and a currently stagnant economic recovery, Wall Street is rooting for efforts to overwhelm the economy with a big shot in the arm.
Here is what four banks have to say about new stimuli and what may result from inflation.
(Spoiler: not much)
Bank of America: ‘A difficult balance, but so far very successful’
Investors were not shaken by inflationary concerns surrounding the stimulus. Inventories – which historically were sold when consumer prices overheated – are close to record highs. Investors also continue to turn towards oppressed companies set to recover as the economy reopens, signaling that they are more focused on profit growth than on potential headwinds of inflation.
Michelle Meyer, head of US economics at Bank of America, puts it succinctly, saying the market is “painting a story of optimism”.
“Market participants are looking for stronger economic growth to raise inflation, but not to trigger the Fed’s tightening too quickly,” the team said in a note on Friday. “It is a difficult balance, but so far very successful.”
The company expects growth of 6% in gross domestic product in 2021 and another 4.5% next year. Such expansion would fill the hole in the economy by the end of 2022, and additional stimulus would further accelerate growth, economists said.
The question is not whether the economy will overheat, but how much, they added. The output gap – the difference between real GDP and maximum potential GDP – is expected to reach its largest surplus since 1973 if Biden approves his proposal, according to the bank.
Still, with the Federal Reserve actively pursuing inflation above 2% for a period of time, the hole in the economy probably needs to be filled before there is a return to stable growth, the note said.
UBS: ‘Increasing only gradually’
The White House package may exceed what is necessary, but the effect on inflation “is likely to be small,” UBS economists led by Alan Detmeister said in a note to customers on Wednesday.
The bank’s approximate estimate sees the proposal generating about 0.5 more points of inflation compared to a scenario in which no additional aid is approved.
Price growth is expected to increase “only gradually” after “modest” inflation in the first half of 2021, the team said. Basic personal consumption expenditures – the Fed’s preferred inflation indicator – will rise to 1.8% in 2022 and 1.9% the following year, still tending below the central bank’s target. Inflation is expected to exceed 2% after 2023 if the economy can become even stronger, UBS said.
The forecast does not yet take into account the currently proposed stimulus measure, but the package “presents a small upside risk” and is unlikely to bring inflation to 2% before, economists added.
Goldman Sachs: ‘Models currently alleviate slack’
Economists led by Jan Hatzius took a different approach, focusing on models that measure the output gap instead of inflation expectations. The metric depends on estimates of the maximum potential GDP published by the Congressional Budget Office, but these estimates change over time as the US economy evolves.
The story suggests that CBO’s calculations are flawed and “currently underestimate the slack” of the American economy, Goldman economists said on Wednesday. The team claimed that the office model suffers from endpoint bias, which means that it interprets short-term changes as a reversal of a long-term trend.
Economists don’t have to look far to find other examples of this, according to the bank. The CBO’s estimate of potential GDP was consistently revised downwards from 2009 to 2017, when real GDP fell below the maximum potential. The revisions turned positive in 2018, when real GDP exceeded the estimated maximum. The CBO reinterpreted what first appeared to be overheating and then to be a catch-up towards full potential, economists said.
“Both in the fall and in the rise, the real GDP was, therefore, a leading indicator for the estimated potential GDP, indicative of endpoint bias”, they added.
Overall, Goldman projects that the output gap is currently more than twice the size of the CBO estimate, supporting the bank’s view that “the risk of inflation remains limited”, even with its growth estimates above consensus. The CBO model is also difficult to reconcile with inflation over the past decade, Goldman said, as price growth has continually fallen short of the Fed’s target, even as the budget sees the economy overheat.
Deutsche Bank: ‘An unusual moment in macro history’
A special report published on Friday by Deutsche Bank chief international strategist Alan Ruskin sought to strike a balance. Essentially, he wrote, the next year will be too early to say.
Noting that inflation generally tends to delay growth by up to two years, Ruskin wrote that inflation fears are unlikely to be easily proven to be true or wrong in 2021.
“Some soft US inflation figures will not be entirely clear. Some strong US inflation figures, however, will raise concerns,” he wrote. “There is then some asymmetric distortion inherent in the way markets will think about inflation risks going forward.”
Ruskin foresaw growing fears of inflation for this reason, as his “all right” about inflation risk will not be achievable. In the medium term, he added, “the consequences for the market of a significant acceleration of inflation in the United States are much greater than if inflation does not accelerate.”
Moving away a little, Ruskin noted that this is “an unusual moment in macro history”, where “the ‘stars’, as they relate to fears of inflation, have aligned themselves” because economists of various traditions, from neokeynesians to monetarists and the school Austrian, all have growing evidence showing more, rather than less, risk of inflation.
These elements include the largest growth in money supply in history; the strongest real growth expected in 70 years; the closing of a large negative output gap and some of the most accommodating financial conditions ever recorded.
Ruskin wrote: “There is a sense of ‘if not now, then when?'”