Taps Coogan – February 23rd, 2021

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One of the big questions that we’ve batted around since the early days of this site has been how long the ‘Free Lunch’ phenomenon at the Federal Reserve could go on for.

The ‘Free Lunch’ phenomenon is the dynamic whereby seemingly no amount of Fed stimulus could push PCE inflation higher. The stimulus did, however, endlessly push financial markets higher, creating a win-win dynamic for markets that has propelled them to stratospheric levels, with only transitory interruptions, regardless of whatever the underlying economy was doing.

As we’ve written about this dynamic over the years, and tried to point out its fallacies, it’s always been clear that at some point the bill would come due. That point has always been just over the horizon, something that one could imagine but not see.

That’s starting to change and even very dovish establishment economist are starting to worry about too much stimulus, as Allianz Chief Economic Advisor Mohamed El-Erian recently alluded to in a discussion with CNBC‘s Joe Kernen.

Mr. El-Erian:

“The market mood has changed. It’s no longer whether yields are going higher. It’s when are moves too big…?”

“So far people think that this move (rising 10-Year treasury yields), while not welcome, is fine… What we are seeing is interestingly even those who have long supported a big fiscal push are saying be careful. Going big (now) may be too big. You had Olivier Blanchard over the weekend who joined Larry Summers who said ‘Look, I’ve always supported fiscal injections, but this may be too much.’ This may result in an output gap, The multipliers are too high, and guess what? You’ll get inflation. He didn’t even mention financial stability risk.” 

“It is (that) you may destabilize inflation expectations that the market is really worried about.”

When Larry Summers is warning about too much stimulus, especially with this political backdrop, you know something has fundamentally changed.

As we’ve been pointing out for years, the transmission mechanism for Fed stimulus has long been broken, trapping most new liquidity within financial markets and the Federal Reserve itself. The advent of helicopter money has ‘fixed’ that bug.

Whatever policy choices the Fed makes from this point forward, the ‘Free Lunch’ era is coming to an end. Pernicious inflation isn’t going to be the panacea that the Fed imagines.

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