Four More Reasons to Worry About U.S. Inflation

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One of the big questions looming over the U.S. economy is how soon the recovery from the coronavirus slump will start to generate inflation. In a recent column, I offered five reasons to be worried about the risk of an unpleasant surprise, in which inflation returns faster than people expect.

I’m now seeing four more.

Let’s start by exploring what’s happening in the five areas of concern that I highlighted earlier.

  • Inflation math. When the coronavirus crisis hit back in March, U.S. consumer prices dropped for a couple months. Soon, those months will have passed and we will have a  new basis of comparison for year-over-year inflation readings, adding about half a percentage point. The Federal Reserve’s preferred measure was running at 1.5% in December, so it could reach the central bank’s 2% long-term target this spring.
  • Demand surge versus reduced supply. There’s increasing evidence that the economic slump has wiped out a lot of small businesses, including restaurants and others in the leisure and hospitality sector. This means there won’t be enough capacity to meet resurgent demand as vaccinations allow more people to go back to their pre-pandemic activities. The upshot will be higher prices.
  • Resource misallocation. A lot of businesses are changing the way they operate – for example, by having more employees work from home or moving offices away from big cities. As a result, a lot of the country’s capital, such as commercial office space in midtown Manhattan, will prove less useful than it was before the pandemic. This misallocation of resources will likely restrain productivity growth, adding to inflationary pressures.
  • A patient Fed. At his latest news conference, Chairman Jay Powell reiterated that the central bank will be in no rush to remove monetary stimulus, even if inflation accelerates. On the contrary, officials want inflation to overshoot the Fed’s 2% target for a while, to overset past downside misses and keep expectations anchored close to 2%.   
  • Fiscal stimulus. I predicted that the government would be inclined to aggressively support the economy with added spending, in part because the economics profession has become less concerned about federal debt burdens. Now that seems even more likely to happen, as the Biden administration and a Democrat-controlled Congress work on a sizable fiscal stimulus package.

But that’s not all. There are several more reasons to expect faster growth and higher inflation.

  • This recovery will be different. Slumps brought on by pandemics tend to end faster than those brought on by financial crises. So this recovery should be faster than the last.
  • Many households have resources to spend. The government’s rescue packages, by providing cash payments and added unemployment benefits, have done a lot to mitigate damage to people’s finances. As a result, Americans as a whole aren’t facing the kind of mortgage-debt and bad-credit problems that plagued them in the aftermath of the 2008 financial crisis. Their capacity to spend is evident in the sharp rise in the personal saving rate, which climbed to 13.4% of disposable income last quarter, compared with 7.5% in 2019. Moreover, households that own stocks and homes have seen their wealth grow quickly.
  • Companies have money. Financial conditions are extraordinarily accommodative. The U.S. stock market is reaching new heights and bond yields remain usually low, giving enterprises ample opportunity to raise funds for expansion.
  • People are starting to expect more inflation. Prices in the market for Treasury securities suggest that investors currently expect the Fed’s preferred inflation measure to average about 2% over the next 10 years. That’s up about half a percentage point from November. This matters, because inflation expectations tend to be an important determinant of actual inflation outcomes.

All this suggests that the Fed, despite its desire to be accommodative and boost employment, might have to pull back on stimulus sooner and with greater force than anticipated to keep inflation in check. Such a move would be a significant surprise, given that in the Fed’s most recent Summary of Economic Projections, the median projection foresees no rate hikes through 2023. This, in turn, would further increase the chances of a volatile market reaction, along the lines of the taper tantrum that the U.S. experienced in 2013.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

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