Upward pressure on prices is already easy to spot, and that’s before the Democrats take over
By MICHAEL R STRAIN / Pic BLOOMBERG
THE question is how much. Prices rising faster than the US Federal Reserve’s (Fed) 2% target would be welcome, but too much price growth could be a problem. If that happens, the Fed could be in a bind.
The Democrats’ surprising victory in the Georgia Senate elections this month is just part of the reason to expect prices to rise.
Just the expectation that Democratic control of the White House and Congress will result in more spending on economic stimulus programmes sent inflation expectations climbing above 2% last week for the first time since 2018.
An increase in the supply of government bonds — which will finance the extra spending — pushes up yields, and the 10-year Treasury yield rose above 1% last Wednesday for the first time since the early days of the coronavirus pandemic.
Economic growth is almost sure to surge this year as the pandemic begins to recede, but the Fed has convinced market participants that it will keep short-term interest rates low. That could be inflationary, too.
And add to the list the Fed’s new monetary policy framework, which is designed to allow for above-target inflation for temporary periods.
This more permissive attitude could change what households and investors expect from prices and from the central bank.
This in turn could create a self-fulfilling situation in which expectations about faster price growth push up actual prices.
Some economists believe that inflation is largely determined by the amount of money sloshing around in the economy.
Despite the Fed’s aggressive measures following the global financial crisis in 2008, financial assets held by households — including currency, checking and savings accounts, and other liquid assets — did not rapidly increase because banks were reluctant to lend.
In contrast, this measure of the stock of money (called “M2”) has increased sharply in the pandemic, rising from US$15.4 trillion (RM62 trillion) in late January to over US$19 trillion at the end of December.
This may be another reason to expect upward pressure on prices.
In addition to these considerations, the pandemic has caused supply-chain bottlenecks that should put upward pressure on prices.
Last month, my delivery of live Christmas garlands was delayed for this reason, and I was told by the vendor that a black market in wreaths had sprung up in its wake.
Because they were harder to get, their price went up. Costs are also rising. Metals, including iron ore and copper, have gotten more expensive, as have commodities like cotton and lumber.
Since these are purchased by manufacturers to make other goods, their rising prices put upward pressure on consumer prices.
In addition, the dollar has been depreciating since the spring, which also creates inflationary pressure by raising the cost of many kinds of production.
The productive capacity of the economy has been diminished by the pandemic, as well.
Businesses have failed, long-term unemployment has increased and workers and capital will need to be reallocated as the economy recovers. This will act to further restrain supply as demand rises.
And demand will surely strengthen because households are sitting on piles of cash. The personal savings rate averaged 7.3% from the end of the 2008 recession until the onset of the pandemic.
In April, it hit a peak of 33.7%. In November, the rate was still 12.9%. Once people get vaccinated and feel safe engaging in a broader range of economic activity, many will want to go on spending sprees.
But while it’s easy to be confident that inflationary pressures will rise, it’s harder to predict how much impact those pressures will have on actual prices.
Recent history doesn’t give much support to the theory that inflation has to be a byproduct of economic expansion or accommodative macroeconomic policy.
From June 2009 through the beginning of the pandemic recession in March 2020, the year-on-year monthly inflation rate as measured by a key price index — the deflator for personal consumption expenditures, excluding volatile food and energy prices — averaged 1.6%.
In the years since the 2008 recession ended, the rate of inflation has only hit the Fed’s 2% target in 13 months.
And that’s despite a recovering economy and extraordinary efforts to stimulate it — including keeping the federal funds rate near zero for six years and purchasing trillions of dollars of assets to encourage home buying.
The unemployment rate fell from 10% in October 2009 to 3.5% in February 2020.
There are also pressures pushing back against an inflation surge.
The economy will still be weak throughout 2021, despite impressive quarterly growth rates and falling unemployment.
Slack in labour markets should restrain wage growth, which will put downward pressure on consumer prices.
The latest inflation data, released on Wednesday, show that that core consumer prices grew slightly more slowly in December than in November, probably for this reason.
Still, I’m expecting some inflation. How large will the surge be? Here, predictions become difficult because inflation dynamics are still not well understood.
Two-percent inflation is currently expected by investors. A rate of 3% over a short time should, in my view, be considered a policy victory by the Fed and Congress, because it would suggest that their efforts stimulate and support the economy.
I think this range is completely plausible. It’s worth noting that inflation in the 3% range is higher than investors currently expect.
Could prices go even higher? At 4%, economists and policymakers may start to get worried that price increases are getting out of hand.
Inflation can spike rapidly. And once inflation has taken hold, it can be painful to get price growth back under control.
Especially worrisome is the possibility that price growth starts to make economists and investors jittery, while the economy is still weak. This would put the Fed in a difficult bind, having to choose between acting to preempt a damaging surge of inflation and allowing the benefits of the recovery to reach low-wage workers and low-income households. I’d be surprised if this happens.
But as the saying goes, predictions are hard, especially about the future. The Fed should prepare itself to be in precisely this situation. — Bloomberg
- This column does not necessarily reflect the opinion of the editorial boord or Bloomberg LP and its owners.