Larry Summers And Stimulus, Manufacturing And Inflation

Summary

• Larry Summers has been warning about too much stimulus - he thinks $1.9 trillion is too much - because it might well bring inflation back.
• Manufacturing output is soaring and significantly adding to inflationary pressures in the sector.
• I've posited before that inflation might make a comeback, we need to be ready for it if it does.

Manufacturing capacity and inflation

We have the purchasing managers index for manufacturing for the US and it's booming.

(US manufacturing PMI from IHS Markit)

Well, that's OK, we like booms, it means we're all getting richer. We don't, however, like this part:

As a result, goods producers registered a severe uptick in cost burdens. The rate of input price inflation accelerated to the sharpest since April 2011. Higher raw material prices, notably for steel, and increased transportation costs were widely linked to the rise.

Costs are going up as well, that's inflation. The problem with this isn't, in fact, that it just means the value of that money we're earning is going down. Rather, it means that if inflation really does come back then someone is going to do something about the inflation. That is, they're going to curb the growth of the economy to get rid of the inflation.

As a general rule we think that, over time, steady growth will beat boom and bust. Because that curbing the inflation takes its time and so we miss out on some of the growth we could have had in a more sober manner.

OK, but that's just manufacturing

It is indeed true that this cost inflation is as yet only in manufacturing. As we all also know manufacturing is only 10% of the economy so we can have 10% inflation there and end up with only 1% over everything - below our target rate in fact. No, of course, it never does work out that way but it is important to recall that manufacturing is only a fraction, a small one, of the economy, not the be all and end all of it.

Unfortunately when we look at the Flash Composite numbers (services and manufacturing, but an incomplete survey) we see the same thing:

Input costs across manufacturing and services soared higher as demand outstripped supply, rising at by far the steepest rate since comparable data were first available in 2009. Service providers registered the steepest increase in cost burdens since October 2009, while manufacturers recorded the quickest rise since April 2011. As a result, firms raised their selling prices at the sharpest rate on record (since October 2009), with panellists stating the increase was due to the partial pass-through of greater costs to clients.

The problem is actually worse in services.

Yes, sure

This is only one month's numbers. It could be just working out the kinks in the system as it reopens. No need to panic as yet. And yet, and yet. We've two reasons why we want to think seriously about this.

The first is that the bond markets are getting antsy. Treasury yields are getting higher at times - prices therefore lower of course. Yes, the Fed's got enough firepower to move prices anywhere they want in the short term but it does show that people are thinking, and seriously, about this problem. Seriously enough that they're buying and selling on the basis of it all.

The second is that we've a good theoretical basis to worry about it.

Larry Summers and stimulus

Larry Summers has been pointing out that he thinks the $1.9 trillion stimulus bill is too high. It's too much money to be pumping into the economy:

In contrast, recent Congressional Budget Office estimates suggest that with the already enacted $900 billion package — but without any new stimulus — the gap between actual and potential output will decline from about $50 billion a month at the beginning of the year to $20 billion a month at its end. The proposed stimulus will total in the neighborhood of $150 billion a month, even before consideration of any follow-on measures. That is at least three times the size of the output shortfall.

In other words, whereas the Obama stimulus was about half as large as the output shortfall, the proposed Biden stimulus is three times as large as the projected shortfall.

From which Summers draws two points. One is nakedly political - come along, this is Larry Summers we're talking about - which is that if we blow all the money on simple stimulus then there's less to spend on what Larry thinks stuff should be spent upon. Not less because there's less money left - we can always print some more - but because there's less room to print and spend more before we get inflation.

The second is that Summers thinks this sort of sum will be inflationary. If he's right about the size of the output gap - always an educated guess rather than a strict calculation - then he's right too. More stimulus than the gap will be inflationary.

We seem to have inflation already

We seem to have inflation already from the readings of the PMIs. Summers is predicting more from the stimulus. The bond markets are already showing small signs of indigestion and pondering future inflation.

We might, actually, be really getting inflation that is. I've given another, entirely, explanation for coming inflation here. The different explanations are not contradictory, they're just looking at the same point in a different way. We can think about the 30,000 foot view of the money supply, we can look at specific details of where inflation is coming from and details of policies leading to it.

My view

My view is that significant inflation is not necessarily already baked into the system. I can be convinced that the PMI and stimulus points are passing phases. That the velocity of circulation of money is going to remain suppressed and therefore we're not going to get roaring, 70s-style, inflation.

I would insist though that the possibility of that inflation is baked into the current economy. If it starts to arrive then the Fed can kill it by reversing QE - which would raise interest rates - or by raising interest rates. Either significantly changes our investment stance.

The investor view

We need to be ready, to be thinking about how we would change our portfolios to deal with resurgent inflation. Real assets are always a good idea. Fixed income - bonds for example - and cash are out as inflation will give us negative returns on them.

Mature companies in FMCG areas tend to do well. As I've said, not so much because they can miraculously raise prices into the inflation but because inflation is those sorts of companies raising prices. Profits and dividends thus tend to track, even if at a lag, inflation.

It's also true that capital heavy and invest now for a prosperous future stocks do badly in inflationary environments. Because the higher interest rates make that delay in returns less valuable. So, again, mature companies with good incomes are desired.

All of this is near exactly the opposite of how we have been investing for capital gains these past couple of decades. But if inflation does return this is what we're going to have to be doing.

Nothing need be done yet, for that possibility is there, not the certainty. But it's worth, as again I've said, digging out some of the old books on how to invest in the face of inflation to remind ourselves about all of it.

There's also one rather scary part about all of this. Other than perhaps Carl Icahn - no this isn't a recommendation of any of his companies - there's just about no one old enough left trading or advising on the markets who has actually been investing in an inflationary environment. We're all going to have to learn this all over again.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.