Could the current price trend be transitory and things return to pre-pandemic patterns by the end of the year?
After a long period during which inflation has persistently undershot the Federal Reserve’s target, the economy has entered a new phase. Federal Reserve officials have tried to strike a reassuring note about this shift, often using the word transitory to describe what they believe is happening. They may well have to become more proactive to ensure such an outcome.
Since the start of this year, indications of inflationary pressures have become more pronounced. In a broad sense, these pressures reflected a combination of reduced or disrupted capacity because of the pandemic and the massive stimulus program enacted in January. As vaccines became more widely disseminated, restrictions on economic activity were relaxed, and consumer spending has boomed. Bottlenecks and other supply chain disruptions have become more widespread.
The culmination of this development was a 0.8% rise in the Consumer Price Index (CPI) in April, the largest monthly increase since 2009. The core CPI (which excludes food and energy) rose by 0.9%, its largest monthly increase since 1982. The April price increases were concentrated in three categories, used cars (up 10.0%), airfares (up 10.2%), and out-of-town lodging (up 7.6%).
The increases in lodging and airfares are hardly a surprise, with many Americans resuming travelling for business and pleasure. The rise in used car prices reflects several factors. Rental car agencies sharply reduced their fleets last year, which has affected the supply of used cars coming to market. At the same time, a shortage of semiconductors has disrupted the production plans of auto manufacturers. Many households have used their stimulus checks as a down payment on a car. The combined effects of higher demand and reduced supply have unbalanced the used car market. Even before the April CPI data, private-sector data on used-car prices had been showing sharp price increases. It should also be noted that house prices (which are not directly measured in the CPI) have also been surging as a result of the pandemic’s effects on preferences of households about where they want to live and very favorable mortgage rates.
While price increases in the April CPI were concentrated in the three categories mentioned above, at the wholesale level there are broader indications of building inflationary pressures. This includes a variety of food items, especially meats and grains. Shipping patterns have been disrupted by the pandemic. Along with other supply chain disruptions, this disruption is driving up prices in many industries. To some extent, firms can absorb these price increases into their profit margins, but they will likely pass more of price increases on to consumers in the coming months.
The expectation and hope at the Federal Reserve are that these price increases will prove to be transitory and that inflation dynamics will return to pre-pandemic patterns by the end of the year. During the past 10 years, the Consumer Price Index increased by 1.7% per year, below the 2% target set by the Federal Reserve. The long period when inflation was below the target has resulted in lower inflationary expectations. For the Federal Reserve, lower inflationary expectations have been problematic because it has made it more difficult to lower real interest rates (interest rates adjusted for inflation) during times of economic weakness.
The Fed’s policymakers have indicated that a period of inflation above 2% would be desirable to bring the average closer to its 2% target. Of course, the Fed does not want much higher inflation. The danger is that inflation expectations could get out of hand. As a former economic adviser to FDR once said: “Having a little inflation is like being a little pregnant.”
There is a germ of truth to this statement. Inflation has a psychological component and can become self-fulfilling. In the current situation, two distinct scenarios could unfold with respect to inflationary expectations. Consumers could conclude that things will return to normal after some short-term price increases and put off taking a vacation or making major purchases until they do. Such an attitude would boost short-term savings and help bring inflation back down. Or, consumers could conclude that they should buy now before prices rise even more. Both scenarios have a self-fulfilling aspect to them.
The Federal Reserve retains strong influence over which of those scenarios wins out. Sometimes, all that is needed is some stern rhetoric about the Fed’s commitment to price stability. Another option would be to announce a timetable for scaling back its program of securities purchases. The Federal Reserve is currently buying $120 billion of securities (a mix of Treasury bonds and mortgage-backed securities) per month. This has provided powerful support to financial markets and the economy. By announcing a timetable for scaling back those purchases, the Fed would signal that it will act as necessary to keep inflation under control. An alternative tool would be to indicate to the market a greater openness to raising interest rates. The Fed’s current forward guidance does not call for any increases in official rates until after 2023. When the Fed next publishes its guidance (in June), there is a good chance that this will change and rates will increase.
For now, however, the Fed seems content to tolerate what it hopes will be a transitory rise in inflation. In the last cycle, many groups that usually get left behind started to do better once the unemployment rate dropped to a very low level. Fed officials have expressed a desire to return to what some call a “high pressure” (low unemployment) economy as quickly as possible. The Fed views the upside from such an outcome as outweighing any transitory rise in inflation.
The Fed’s balancing act is complicated by uncertainty about fiscal policy. Congress is weighing additional large spending programs, as well as some significant tax increases. It should also be noted that one option likely to be adopted is to provide the IRS with more funding for conducting audits and other forms of tax enforcement. Current and former Department of Treasury officials have indicated that this could raise large amounts of revenue without changing tax laws.
The Fed will be watching the choices Congress and the Biden administration make very carefully over the next few months. In many ways, the role of the Federal Reserve in the current environment has been a complementary one to fiscal policy. It could well be that at some point next year, the Fed will find itself having to lean against fiscal policy. That will depend on the mix of spending and tax decisions made over the next few months.
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