The reflation of the American economy following the debilitating effects of the pandemic has begun.
Recent increases in growth forecasts, the January jump in retail sales, trillions of dollars in fiscal aid and stimulus, as well as the prospect of a household-led boom over the next two years, have spurred a debate around the prospects for inflation and rising interest rates.
Concerns about inflation risk are premature and overblown.
Modest increases in inflation, coupled with rising expectations, have fueled an active discussion around fiscal and monetary policy and the risks of pricing to the economic outlook.
In our view, concerns about inflation risk are premature and overblown. Current monetary policy is well-positioned to support the reflation of the domestic economy, a return to full economic potential later this year and full employment over the next three years.
This view is consistent with the Federal Reserve’s longer-run objectives and will not stoke higher inflation on a sustainable basis. Nor will it engender a return to 1970s-style inflation. In fact, if one looks at core metrics of inflation expectations, one will not find indications of hyperinflation, inflation, stagflation or dollar debasement. Instead, one finds indications of long-term price stability.
We expect a transitory midyear bump in top-line inflation because of year-ago base effects from last March and April, when the pandemic set in and caused a plunge in the price of oil, commodities, rents in major urban centers and many services.
The policy error here in our view would be to reverse course in response to what is going to be a temporary deviation from the current and long-term trend in prices. Policymakers at the central bank will look right through this development and continue to focus on what will most likely be a multiyear journey back to full employment rather than preemptively truncate a nascent economic recovery.
U.S. inflation
Our forecast for this year implies that the top-line Consumer Price Index will reach 3% in June and fall back to 2.3% by the end of the year. Similarly, we forecast that the Fed’s preferred measure of inflation, the core Personal Consumption Expenditures price index, will peak at 2% midyear and fall back to 1.7% by the end of the year. This is consistent with forward-looking metrics of inflation compensation and inflation expectations that are priced into financial securities, all of which imply price stability at or near a 2% inflation rate.
Concerns around rising prices are directly linked to the fiscal spending in 2020 that was equal to approximately 20% of gross domestic product and put in place to offset the loss of income during the pandemic. The prospect of another $2 trillion this year and roughly $1.65 trillion in excess household savings has only fueled concerns over the pent-up demand and over-the-top spending by consumers once the pandemic has been contained.
Given that more than 75% of the new relief package is one-time disaster aid and is not a permanent increase in spending, the talk of runaway inflation is not only erroneous but it also ignores the dynamic structural changes in the economy over the past two decades.
The major difference in distinguishing between transitory and permanent price increases is growth in wage income. Although the employment cost index is showing a solid 2.5% increase year over year, this recovery is K-shaped, meaning that wage gains among higher-income earners are outstripping those of lower-income workers. This distorts the true underlying downward pressure on wages. For inflation, it means that a persistent and permanent increase through the wage channel is a nonstarter and that inflation is most likely years away.
Policymakers and the public should not anticipate a sustained upward pressure in the economy while the labor market remains 10 million jobs short of its pre-pandemic levels, real unemployment hovers near 10% and several million people have taken a pay cut in wages to remain on the job.
Current conditions indicate that tepid wage growth and plentiful slack in the labor market are simply not conducive to a persistent increase in inflation. This is why the Federal Reserve has made abundantly clear that it is not interested in raising interest rates until labor conditions return to pre-pandemic levels or what we interpret to be full employment at or below a 3.5% unemployment rate.
Policy implications
The market has priced in a rate hike in the first quarter of 2023, which we think is out of line with the fundamentals. Nevertheless, the backup in interest rates in general and the increase in the five- and 10-year Treasury yields will have gained the Fed’s attention. At this point, the Fed will most likely look to make subtle policy changes that do not alter the size of its balance sheet but extend the duration of its portfolio.
We expect that the Fed will lift interest rates paid on excess reserves (currently 10 basis points) and overnight repo rates (currently zero) by 5 basis points each as early as its meeting on March 15 and 16.
Second, it would not be surprising if central banks began hinting at a possible Operation Twist III – or the simultaneous buying of long-term bonds and selling of short-term bonds. The intent would be to dampen rates at the long end of the yield curve, while extending the duration of its portfolio without increasing the size of the Fed’s balance sheet. The Fed has used this approach twice before – Operation Twist I in February 1961 and Operation Twist II in September 2011.
This would signal to other policymakers, market players and investors that the central bank intends to achieve its policy goals and is willing to inflict losses on those who challenge its credibility.
Quality improvement and the digital economy
Within the community of policymakers and economists, it is generally understood that technological innovations, productivity gains and the rise of the digital economy have mitigated increases in inflation. But many in the financial sector are operating on old heuristics, or rules of thumb, that are no longer adequate to ascertain risks around pricing and the direction of inflation.
For example, quality adjustments over the past decade have resulted in a noticeable impact on the cost of durable goods inside the PCE index. Over the past 25 years, the cost of durables has fallen by 38%. If one includes quality improvement in the auto goods and parts sector, prices have increased by only 9% since 1995.
While those improvements in quality are widely accepted as a tempering factor on inflation, the rise of the digital economy and its impact on the cost of services are not. In fact, we would make the case that the digitization of the service sector is profoundly disinflationary. As Erik Brynjolfsson writes in his book, “Machine, Platform, Crowd,” once something is digitized, the cost of reproduction, distribution and access tends to fall toward zero. This is not your father’s or grandfather’s economy.
With the rise of zero-pricing business models in everything from entertainment to banking and financial trading, this shift is one of the structural changes not included in many of the arguments and explanations on why inflation might be a rising risk.
From our vantage point, those making the case about the return of 1970s-style inflation are prisoners of the past and fighting the wars of the 1960s and 1970s. They are missing the broad structural changes reshaping the economy.
Pricing expectations and the real economy
The recovery of oil, energy and commodity prices has facilitated an increase in the cost of goods used at earlier stages of production and some intermediate goods. Given historic declines in economic activity during the first half of 2020 and the accompanying oil prices – West Texas Intermediate closed at minus-$37.63 a barrel last April 20 amid the supply glut – reflation was always going to be part of the narrative.
So where are we in the real economy with respect to pricing and pricing expectations?
In the January RSM US Middle Market Business Index, roughly 66% of executives surveyed noted an increase in prices paid, but only 41% reported passing along those price increases to clients.
This six-month average of prices paid stands at 60% and that same metric for prices received rests at 42%, both near current levels. Looking forward, 67% of executives surveyed for that January report expected prices paid to rise and 60% stated that they intend to pass along those price increases to customers; both of those numbers were above their respective levels of 63% and 52%.
Firms that constitute the beating heart and soul of the real economy are not pointing to a near-term risk in pricing.
This implies that current concerns about an immediate and permanent increase in the price level – that is the definition of inflation – are overblown. But it will be interesting if firms that for years have not had pricing power suddenly find that they have that power and that clients are willing to accept higher costs.
Given the modest backup in interest rates and inflation expectations – both remain near 2% – this will be one of the more interesting economic narratives this year and next. Right now, firms that constitute the beating heart and soul of the real economy are not pointing to a near-term risk in pricing to the economic outlook.
Moreover, once one examines core forward inflation expectations, it is difficult to make the case that there is near-term inflation risk. For example, the Fed’s preferred forward-looking inflation metric, called the five-year, five-year forward inflation expectation rate, stands at 2.19%. That is up from a pandemic low of 0.61% posted on March 9 last year. And looking at a longer-term view, the current level is well below the 20-year average of 4% and stands at or near the Fed’s long-run 2% target.
Neither inflation expectations in the real economy nor pricing metrics over the next decade imply a significant risk of the return of debilitating price increases in the near term or 1970s-style inflation over the long run. This data does not scream inflation, stagflation or dollar debasement. Rather, it implies long-run price stability.
1970s-style inflation
Aggressive fiscal and monetary policies put in place to offset the economic impact of the pandemic have stoked a discussion around the return of 1970s-style inflation. What that refers to is the type of inflation observed in the U.S. between 1965 and 1985, when the Consumer Price Index averaged 6.1% with a year-over-year high of 14.8% posted in March 1980.
So what caused that?
The popular explanation is that it was social spending on the Great Society. In reality, it was other factors as well: spending on the Vietnam War, domestic social spending, the arrival of the baby boomers into the labor market and the twin oil shocks of 1973 and 1979. The result was a two-decade effort to tame inflation.
But the ensuing oil glut and global central banks’ overriding commitment to price stability set the stage for the next three decades of disinflation and then sustained low inflation.
When one looks at the current economic conditions – tepid wages, slack in the labor market, tempered oil and commodity prices, and accommodative monetary and fiscal policies – it is difficult to accept arguments that the return of 1970s-style inflation is imminent.
It is important to note that the U.S. economy during that era was one predicated on manufacturing. That was well before the rise of services, information and the new digital economy that defines the current era. Making policy decisions around conditions that were last seen several economies ago is the working definition of fighting the last war.
Phillips curve flattened
Last year, the Federal Reserve changed its policy regime to reflect the broader structural changes that have occurred over the past two decades. The new flexible average inflation targeting regime is organized around achieving an average 2% target over a period of time.
Given that core PCE inflation – the Fed’s choice for its 2% inflation policy target – has averaged 1.6% since the last economic expansion, the Fed is positioned to let inflation run above target for a period of time.
In fact, Federal Reserve Chairman Jerome Powell, in his recent semi-annual testimony on monetary policy, indicated that the central bank is prepared to let inflation run above target for three years before it may choose to change the path of monetary policy. To that point, policy decisions (rate hikes, asset purchases and forward guidance) will be based on shortfalls of employment from its maximum levels and not deviations. Given that we expect core inflation to reach 2% this year, we do not anticipate any rate hikes until late 2023 or early 2024.
A decline in the unemployment rate by itself will not be sufficient to trigger an increase in rates or other forms of tighter monetary policy without other evidence that inflation is at risk of moving above mandated levels consistent with price stability.
In short, the long-term decisions around monetary policy, standard Phillips curve models or the tradeoff between inflation and unemployment have been de-emphasized as the Fed formulates its policies.
Why is that?
Over the past economic cycle, the relationship between inflation and unemployment has flattened out. While measures of labor market tightness or slack can be somewhat helpful in forecasting inflation, estimating the direction of prices remains difficult and subject to random noise and events.
Our research suggests that the Phillips curve flattened out notably over the past few decades as the economy transitioned from one based on manufacturing to one based on services, information and digital technology.
Based on what is referred to in policymaking circles as a lagged accelerationist Phillips curve model – which uses actual lagged inflation as a proxy for inflation expectations – that implies that a half percent reduction in the unemployment rate would result in a 0.1 percentage point increase in inflation. Under current circumstances, one might expect a modest 0.2 to 0.3 percentage-point increase in inflation based on our year-end 4.7% unemployment rate target.
But the best research around this quantitative approach implies that inflation expectations tend to negate or offset accelerationist models, so there is likely downside risk to our midyear forecast of 3% in the CPI and 2% in the policy-sensitive core PCE index.
Bond yields
The yield on the 10-year government security has increased 48 basis points since the start of the year. The yield curve – or the difference between yields on the 10-year versus the 2-year Treasury – has increased from 96.05 basis points on Jan. 1 to 136.08 currently.
While we expect the Fed to keep its policy rate at zero, anchoring the front end of the curve, we expect the 10-year to end the year at 1.6%, up from our year-ahead forecast for 2021 of 1.3%. This just about perfectly captures the building optimism on economic reflation and improved lending conditions that often follow the steepening of the U.S. yield curve.
The brightening outlook is a positive development that reflects the move of the economy back toward the use of its full capacity to produce goods and services and is not signaling a significant increase in inflation because of a likely rise in wages, employment and pricing.
For more information on how the coronavirus pandemic is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
