Fed set to look beyond possible post-pandemic inflation shock

Washington

BETWEEN the closed theatres and restaurants, the prices slashed by airlines and half-empty hotels, and the government benefits paid or in the pipeline, Americans may have as much as US$2 trillion in extra cash socked away by this spring.

For the Federal Reserve, that is both blessing and curse: fuel for the economic recovery once Covid-19 vaccines take hold and people can travel and shop freely, but also the possible spark for a surge in prices that policymakers already are bracing to explain.

Fed policymakers have little doubt that costs for many goods and services will jump this year, a bitter pill for consumers if petrol, travel and other prices start to rebound from sharp declines last year. But, Fed officials argue, that's part of getting back to normal, not the start of a more persistent inflation problem.

"As people return to their normal lives . . . there could be quite exuberant spending and we could see upward pressure on prices," Fed chair Jerome Powell told a Princeton University seminar earlier this month. "The real question is how large is that effect going to be and will it be persistent?" Mr Powell said. "A one-time increase in prices . . . is very unlikely to mean persistently high inflation." Mr Powell and other Fed officials will likely reinforce that message after their two-day policy meeting this week. Few if any changes are expected to the Fed's policy statement and no new economic forecasts are scheduled to be released.

But Mr Powell will likely address inflation in his post-meeting news conference. Indeed, he and other top Fed officials in recent days have rolled out a sort of public service announcement about what's ahead: Ignore the coming sticker shock, they say, because even if inflation moves above the Fed's 2 per cent target this year, it likely won't last and won't change the central bank's very long horizon for lifting interest rates.

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"I will be looking for sustained improvements in realised and expected inflation" before concluding that the economy has hit or exceeded the central bank's goal, Fed governor Lael Brainard said earlier this month.

The comments reflect the challenge policymakers face as the economy emerges more fully from the pandemic over the year.

Fed policy remains firmly in rescue mode, with interest rates pinned near zero and no change expected for perhaps three years to come. The economy remains about 10 million jobs short of where it was last February.

But President Joe Biden's push to accelerate vaccinations and ramp up pandemic-related spending could change things fast.

"Excess" savings may hit US$2 trillion if Mr Biden's full US$1.9 trillion pandemic spending proposal is approved by Congress, Bank of America Securities global economist Ethan Harris and other analysts wrote this week, and "we simply do not have any historical experience" to estimate how an economy transitions out of a pandemic and back to normal.

Inflation numbers this year could cause numerous headaches - for families fretting about food or petrol bills, or politicians wondering if Fed policy risked a return to 1970s-style price surges.

The data itself could be erratic.

Headline inflation cratered from May to June last year, then spiked in the months following - tracking the economy down at the start of the pandemic, then back up as the recovery began.

Those "base effects" will mean higher inflation numbers this spring, but likely lower ones in the summer. Neither will say much about the underlying inflation trends that the Fed actually cares about.

Investors will be listening closely to how the central bank talks about those price moves.

"You will see iterations from the members themselves maybe moving to some sort of consensus about how to judge this," said Jason Thomas, global head of research for Carlyle Group, referring to the Fed's policy-setting committee. It may be late this year, however, before the noise eases enough for policymakers to judge how inflation is actually behaving.

Under a framework adopted last year, the Fed has pledged not to react to rising prices by raising interest rates too hastily, as it has in the past, nipping off economic and job growth.

Instead, it will wait for a well-established trend in which inflation "has risen to 2 per cent and is on track to moderately exceed 2 per cent for some time". What that means in practice remains unclear. The aim to "moderately exceed" the inflation goal, a concession to years when inflation was too weak, has been interpreted differently by different policymakers.

In a recent poll by the Brookings Institution's Hutchins Center on Fiscal and Monetary Policy, two-thirds of respondents said the Fed hadn't "provided enough detail" about the new strategy.

Even determining when inflation has "risen to 2 per cent" may not be so straightforward. Fed vice-chair Richard Clarida has said that phrase "refers to inflation on an annual basis", implying that the 2 per cent level must be maintained for 12 months.

But that one-year language is not in the Fed's policy statement, and Mr Clarida did not detail how it would be calculated in practice.

Former Fed governor Randall Kroszner sees Mr Clarida's comments as a "trial balloon", part of an ongoing debate about how the new framework will be applied.

"People are thirsting for clarity," said Prof Kroszner, who is a professor and deputy dean at the University of Chicago's Booth School of Business. "If the markets respond in the right way it could evolve to what they mean in practice."

Meanwhile, Fed officials' views have ranged from seeing prices as set to rise in a meaningful way, to seeing inflation stymied by global trends, technology and other forces.

Even if Americans soon start to splurge, Mr Powell said that's unlikely to break the Fed's core concern that inflation is too weak.

"Dynamics will change, but we don't think they change quickly or on a dime," Mr Powell said during the Princeton seminar. "Too-low inflation is the much more difficult problem." REUTERS