Biden’s Big Boom and Big Risk: 3 Scenarios

As I wrote in my last 2 posts, “Central Banks vs Bond Markets” and “Biden’s Stimulus Plan, Inflation, and Interest Rates”, there is a realistic risk of inflation and an interest rate shock for 2023, with potentially serious consequences for all markets and the real economy, and perhaps also politics. Lets explore 3 possible scenarios, with numbers.

Although inflation “predictions” are notoriously wrong and generally simply based on a slow-moving “auto-regressive process” (i.e. that inflation is most explained by past inflation), still, assumptions are what make the difference between scenarios. Other than past inflation, here are the variables that matter in building scenarios about how much inflation and how severe of an interest rate shock could be coming:

1. The “fiscal multiplier” over a 24 month period (more on this later).

2. Personal savings and spending behaviour by households.

3. Estimated potential GDP, which goes hand-in-hand with the estimation of the output gap.

4. Velocity of money.

5. Monetary policy.

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Growth, fossil fuels, and “green” energy

Is there a “limit to growth” as exposed in the Meadows Report? Our global system works on “growth” of production to generate employment and income, which takes several forms: wages, incomes for entrepreneurs and stock holders, capital gains, rent and interest income, which themselves finance State income (taxes!) and other institutional incomes. Private and public pension funds run on “total returns” from assets, themselves tied closely or loosely in the long run to the underlying “cake” that we all “eat”, which is also called Gross Domestic Product: the total economic value generated per year.

The total “cake” we produce and consume ultimately comes from 2 broad factors:

1. Total number of workers actively working / producing.

2. Total factor productivity, which we can simply think of as the “efficiency” of producing economic output (value) with a certain quantity of inputs: time, energy, land, machines, infrastructure, etc.

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Why are interest rates so low and are stocks overpriced?

Interest rates are at long term historical lows and stock pricing is historically high, based on various metrics. Why and what is likely to happen?

Asset prices and “yields” go in opposite directions

It is important to start with the basics: asset prices and “interest rates” go in opposite directions, or more precisely, asset prices and “expected yields” go in opposite directions. Indeed, if you pay the very same asset 100$ instead of 200$, it is a better “deal” at 100$: you pay less for the same future expected value. Hence, when asset prices go UP, expected yields go down on those same assets. That is, buying into stocks are sky-high prices is not the best!

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