The Inflation Outlook

Judging by recent phone calls and email queries, inflation is a serious concern among investors this year. We can expect to see some reflation, a rebound in prices that were depressed during the pandemic, but a broad-based increase in underlying inflation is unlikely. Opinions may differ, even among Federal Reserve policymakers, but the central bank’s revised monetary policy framework suggests no need to take the foot off of the gas pedal anytime soon.

Large federal budget deficits do not cause inflation. We ran huge deficits (as a % of GDP) during the 1980s as inflation fell.

Accommodative monetary policy may lead to higher inflation. Last summer, the Fed signaled that, following a period of inflation below 2%, it would shoot for a period of above-2% inflation. That’s a sharp contrast to the previous view that the Fed should act preemptively (that is, raise rates in advance), to head off higher inflation. Officials are confident that they can get inflation higher, but the Fed has struggled to reach its 2% goal in recent years.

Inflation is a monetary phenomenon, but observed through pressure in resource markets. In the details of the December reports on producer prices and import prices, there is evidence of pipeline pressures in prices of raw materials. However, there is little evidence that firms are able to pass higher costs along. In the ISM surveys, supplier delivery times rose further in December. Normally, that would be a sign of demand outpacing supply. However, this increase is reflective of supply chain issues related to the pandemic. Manufacturers have adapted to the pandemic, but it hasn’t always been easy. Still, there is limited inflation showing up in finished goods. Import prices have begun to pick up, but increases are concentrated in oil and industrial inputs. There is little inflation in imported finished goods.

The labor market is the widest channel for inflation pressure. Average hourly earnings were reported to have risen 5.1% year-over-year in December. However, that increase reflects job losses at the lower end of the wage spectrum (which raises the average). The Employment Cost Index (4Q20 data due January 29) do not suffer from this compositional effect (and also include benefit costs) and are expected to have risen moderately. Overall, labor costs pressures are low. Firms are also finding that the trend of working remotely allows them to cast a wider net in looking for talent, restraining labor costs.

There are two general post-pandemic theories about higher inflation. One is that increased savings and pent-up demand will lead to a surge in demand once vaccines are widely distributed, driving prices higher. One lesson of the 1918 pandemic is that consumers will be eager to make up for lost time. However, supply should also pick up quickly. Certainly, we ought to see airfares and hotel fees rebound from pandemic lows, but these would be reflationary, transitive, and not indicative of a higher underlying trend. Currently, there are plenty of empty hotel rooms and idle airplanes, which can be brought into service as demand picks up.