Chief Economist Scott Brown discusses current economic conditions.
The details of the January Producer Price Index showed a further surge in prices of raw materials. Breakeven inflation rates (the yield spread between inflation-adjusted Treasuries and fixed-rate Treasuries) have continued to move higher. Retail sales were unexpectedly strong in January, fueled (apparently) by an increase in pandemic assistance, boosting fears that further fiscal support will add to inflation pressures. However, the outlook for consumer price inflation hasn’t changed much. Inflation fears have been a factor in lifting long-term interest rates, but bond yields should rise as the economy recovers.
It's important to recognize that it takes a gigantic increase in the prices of raw materials to have much of an impact on consumer price inflation. That’s because there are many other costs in bringing finished goods to market (such as labor, transportation, advertising, etc.). Moreover, services account for about 63% of the Consumer Price Index.
Economists do not fully understand the great inflation of the 1970s and early 1980s. The story we tell is that an oil price shock fed through to the overall consumer price inflation, lifting wage inflation and inflation expectations, accommodated by easy Fed policy. The double-dip recession of the early 1980s was necessary to wring inflation expectations down, but it was still a long battle for the Fed to win the public’s confidence as an inflation fighter. That battle has long been over. Expectations remain well-anchored.
Breakeven inflation rates, which aren’t exactly the same as inflation expectations (but close enough), have picked up from the lows of last year, but aren’t especially high (2.3% over the five-year horizon, 2.2% over the 10-year horizon). That is consistent with the Fed’s revised monetary policy framework. Following a period of inflation below 2% (as we’ve seen recently), the central bank will shoot for a period moderately above 2%. "Moderately” likely means 2.5% or 3%. Also note the breakeven inflation rates reflect expectations for the Consumer Price Index. The Fed’s 2% goal is for the PCE Price Index, which tends to trend a few tenths of a percentage point less than the CPI on a year-over-year basis.
Retail sales jumped in January. While some of that reflects the seasonal adjustment (a smaller decline following a weak holiday shopping season), it appears to have been supported by the extension of unemployment benefits. While it’s still early, the retail sales figures have lifted expectations for 1Q21 GDP growth and added to fears that further fiscal support (Biden’s $1.9 trillion proposal) will add to inflation pressures. In fighting economic downturns, the mistake usually made is not doing enough or taking away support to soon. Erring on the side of doing too much may lift inflation somewhat in the short term, but should not have a long-term impact.