The Inflation Outlook

Chief Economist Scott Brown discusses current economic conditions.

For a variety of reasons, many investors are worried about higher inflation. While we may see reflation (a pickup in prices that were restrained due to the pandemic), a significant increase in underlying inflation appears unlikely.

The Consumer Price Index (CPI) measures the cost of a basket of goods and services over time. The basket represents what a typical consumer would purchase. The CPI is not a true cost-of-living index and personal inflation experiences will vary. The Personal Consumption Expenditures Price Index (PCE Price Index), the Federal Reserve’s chief inflation gauge, uses the same weights as the CPI, but allows the basket to change as consumption patterns change, and tend to rise a few tenths of a percentage point per year more slowly than the CPI. Economists often exclude food and energy prices, but not because they don’t matter. Rather, these prices are volatile and we are interested in the underlying trend.

Money supply measures surged in the early months of the pandemic. However, the relationship between the monetary aggregates (M1, M2, etc.), growth, and inflation broke down in the late 1980s. Money supply growth is not a key factor in the setting of monetary policy. The surge in liquidity during the pandemic helped relieve financial strains, supported growth, and lifted asset prices, but has not boosted consumer price inflation.

The nonpartisan Congressional Budget Office is projecting a $2.3 trillion federal budget deficit for the current fiscal year. That’s 10.3% of GDP (following 14.9% in FY20) and does not include further fiscal support (which may add up to another $1.9 trillion). However, large federal budget deficits DO NOT cause higher inflation. In the 1980s, the U.S. ran deficits on the order of 5% of Gross Domestic Product, while inflation trended lower. Japan currently has a debt-to-GDP ratio of over 235%, yet continues to battle deflation (a general decline in the price level). The U.S. budget deficit rose to 10% of GDP in FY09, with no appreciable increase in inflation.

The pandemic has disrupted supply chains, lengthening supplier delivery times and raising input costs, but these pressures should recede as vaccines are distributed and activity returns to normal. The U.S. trade deficit widened during the pandemic, putting some downward pressure on the exchange rate of the dollar and upward pressure on commodity prices. Note that the dollar surged amid a flight to safety in the early part of the pandemic, then fell back, but the Fed’s Broad Dollar Index is down about 3% since the end of 2019 – not a huge decline. Moreover, while inflation in raw materials has increased, U.S. firms continue to face difficulties in passing higher costs along and there is little inflation in imported finished goods.