Keynesians vs. Keynesians
- The debate between Lawrence Summers and Paul Krugman on the risks stemming from Biden’s fiscal stimulus is all but an obscure academic dispute. The questions they raise are key to the trajectory of long-term interest rates in the US.
Keynesians were fairly united when they were in the policy wilderness, but now that their views are dominant and they can finally seize the levers of macro policy, dissent is emerging. Lawrence Summers is taking issue with Biden’s USD1,900bn emergency stimulus. His concerns are twofold: first, that it may be too big and exert enough pressure on capacity to trigger an acceleration in inflation which would ultimately force the Fed into an early and potentially recessionary tightening; second, that it could kill the chances of a medium-term public investment programme which the US needs to lift potential growth. Paul Krugman disputes that closing the output gap faster would necessarily beget inflation, and considers that, even if that happened, it would not necessarily be a bad thing for the Fed.
Your humble servant confesses his admiration for both economists, who both make compelling cases. But taking sides is probably unavoidable in this dispute which may shape the economic debate for some time.
That the Biden’s plan, unless it is significantly shrunk to pass Congress, can close the US output gap by the end of 2021 is very plausible. However, this overheating phase is likely to be short, and given the decline in trend inflation over the last 15 years we don’t think this can easily trigger a lasting shift in the consumer price regime. For this to happen we continue to think that the institutional set-up of the labor market would have to change. Given the opposition of two moderate democratic Senators to tagging the hike in the minimum wage to 15 dollars to the fiscal bill, such risk is for now probably under control. However, if a lasting acceleration in inflation were to materialize, we think the consequences for the Fed could be quite problematic and that the risk of inappropriate monetary policy, either too tight or too loose, would be significant.
This is why we continue to think that the Biden stimulus is consistent with a further rise in US long-term interest rates. By the middle of this year, it will be difficult to know whether the mechanical rebound in inflation is the signal of something more structural or not. But market focus will be on the Fed. Either the Fed complies with its pledge to accept inflation overshooting and continues to “talk dovish”, thus allowing market-based inflation expectations to continue rising; or the Fed gets impatient and starts “talking hawkish”, thus making real interest rates rise. In both cases, nominal yields would probably rise.
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