Congress just passed a 1.9 trillion-dollar stimulus bill. There are concerns and confusion about what this massive amount of money injected into our economy will do. Let us look at a simplification of the issue. With 10,000,000 unemployed and a pandemic still raging, there is a big “hole” in our economy. The official economic term is an “output gap.” An Output Gap is a difference between what the economy could produce if it had full employment and entire factory and business utilization and what we are making right now. There is no doubt that there is currently an output gap. However, no one knows how big it is. If we think of the output gap as a “hole,” then the stimulus is pouring dirt into the hole to fill it up. The danger is that once the hole is full, more dirt applied becomes a “mound” of excess demand-people who want to buy more than the economy can produce. This excess demand can result in inflation.
Over the past month, the interest rate on 10-year maturity government bonds has nearly doubled, indicating that the market is worried about inflation. The Federal Reserve Bank has signaled that it will tolerate a rise in inflation. Inflation is a great benefit to the government because it helps to pay back debt with “cheaper” dollars. The only way to service the vast government debt is to suppress interest rates by the Fed and have inflation. The danger of inflation is that, like a campfire, it can get away from you. 3% inflation is tolerable – 5% inflation would be terrible for both the stock and bond markets.
If inflation is only slightly higher, markets can live with that. Suppose inflation begins to “get away from us.” In that case, the Fed will either have to control the entire bond market with massive bond-buying or significantly raise interest rates. Neither is a good choice. Benold Financial Planning will be watching this closely, and we will navigate through this storm the best that we can.
