Morning Commentary: The Great Debate: Sustained vs. Transient Price Pressures
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The Great Debate: Sustained vs. Transient Price Pressures
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Andrew Kositkun Senior FX Advisor
This past week, President Biden signed the $1.9 trillion American Rescue Plan into law. The combination of massive fiscal stimulus and COVID-19 vaccine rollouts combine to be a powerful tailwind for growth in real activity that will lead to a hot economy and upward price pressure. The debate isn’t if there will be inflation but whether inflation will be contained or troublesome. Contained inflation is welcomed by the Federal Reserve, whereas troublesome inflation likely forces a quicker exit from super-easy monetary policy and raises the risk of a policy mistake.
Significant positive base effects, aka a low starting point, should lead to a jump in the year-over-year inflation rate. The reopening of the economy should also give a considerable boost to some beaten-down categories, such as airfare and lodging, as well as other categories with short-run demand and supply imbalances. Despite the expected rise in prices, there is a strong argument to be made against a rapid and sustained acceleration in prices that marks a true inflation regime shift. Three key arguments against a rapid and sustained rise in prices are as follows:
The Phillips curve, which relates price pressure to the labor market, has flattened. As such, the inflation response to a tightening economy has weakened over time.
Inflation expectations have become a more significant driver of inflation. Regression analysis shows a general uptick in the importance of inflation expectations as an anchor and driver of the trajectory of inflation over the years. While market-based measures have improved recently, a broad basket of inflation-expectation measures remain lower compared to a decade ago.
Monetary policy is seen as credible. Market data shows that long-run inflation expectations remain well anchored against short-run price fluctuations. This is a sign that markets believe in monetary policy credibility. The Fed’s goal under flexible average inflation targeting (FIAT) is to allow a period of above-target inflation to make up for previous shortfalls. However, the Fed will not tolerate aggressively strong inflation and has the tools, such as reducing its balance sheet and implementing rate hikes, to respond if needed.
Bottom line: Inflation is coming, and while it could become a problem in later years should the economy continue to run hot, a flatter Phillips curve, the increased importance of inflation expectations and credible monetary policy suggest that near-term inflation pressures should be more contained.
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