How the Fed Will Respond to the Coming Inflation Scare
(Bloomberg Opinion) -- With a new fiscal package to support the U.S. economy through the winter and the prospect of households unleashing substantial pent-up demand in 2021, the set up for faster inflation is better than it has been for decades. But don’t expect the Federal Reserve to tighten monetary policy next year in response – even if inflation comes in higher than central bankers are forecasting.
The economy will benefit from a slew of substantial tailwinds in 2021 that can leverage on the rollout of Covid-19 vaccines. Widespread vaccination will spark consumer spending next year, fueled by pent-up demand and a massive surplus of saving. The newly announced $900 billion fiscal aid package is the icing on the cake as it will leave the economy on firmer footing from which to launch in the spring.
It is not hard to imagine that at some point next year reports will show the rate of inflation rising above the Fed’s 2% target. Considering the lost travel and dining opportunities this year, the greatest pent-up demand is likely in the leisure and hospitality sector. Yet that same sector has also suffered some of the greatest supply disruptions due to closures and laid-off workers. It is reasonable to expect that the surviving companies will have stronger pricing power.
While faster inflation might rattle some market participants, the Fed will likely remain calm. During the press conference that followed the December Federal Open Market Committee meeting, Fed Chair Jerome Powell said the central bank would tend to view such inflation as the result of one-time price changes rather than the beginning of a sustained inflationary process that forces policy makers to take action. They view these kind of price shocks as having transitory impacts on inflation.
It’s hard to see how we get interesting inflation numbers that are concerning in the face of excess capacity in the economy. The output gap, or the difference between where they economy is and where it should be, was likely around 5% of gross domestic product going into the fourth quarter. The unemployment gap, or the difference between unemployment and the natural rate of unemployment (around 4.1 percentage points according to the median FOMC projection) was 2.6 percentage points in November.
Even so, how fast those gaps disappear will influence the Fed’s reaction to any high inflation numbers that pop up next year. That means the inflation question is not about inflation alone, but inflation combined with how quickly the economy recovers. The risk for the interest rate outlook is that the economy recovers to full capacity operating levels faster than policy makers or market participants expect.
For an example of how the economy might recover faster than expected, consider that the consensus estimate for fourth-quarter growth is just under 4% while the Atlanta Fed’s GDPNow current estimate is 10.4%. Although the fourth quarter might not turn out to be quite so rosy given rising Covid-19 cases, the Atlanta Fed number still illustrates the possibility of some very good outcomes for the economy. For another example, consider that the $900 billion fiscal package is about 4.5% of GDP, or just about the size of the output gap. Imagine the possibility of being on the edge of full capacity already when the vaccine has been sufficiently distributed to allow the resumption of normal activities.
To be sure, any estimates of the output or unemployment gaps are just that — estimates. They will raise some worries about reports showing higher rates of inflation yet still leave the Fed hesitant to change the expected path of rate increases. The Fed will believe the economy is operating closer to full capacity if wage growth accelerates meaningfully beyond the 3.5% seen in July 2019, the high of the last cycle. That would help the clear the way to higher interest rates.
My instinct is that getting all three of these pieces to come together makes inflation more of a 2022 story than a 2021 story. At this point, the 2021 story still looks less like real inflation and more like an inflation scare. And with its new policy strategy, the Fed won’t scare easily.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.
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