Is inflation poised to return?

Putnam Fixed Income Team, 02/11/21


  • Food and core goods prices rose with the pandemic and remain elevated as they are impacted by supply distortions.
  • The slow recovery in the labor market is likely to temper inflation.
  • We cannot dismiss the possibility the Fed may slowly reduce its bond purchases as economic activity picks up over the medium-term.

The U.S. Federal Reserve and other central banks have sounded more upbeat as they upgraded their growth projections. Along with this changing central bank language came the inflation debate. We believe that pandemic-related bottlenecks have temporarily lifted U.S. inflation. Still, the underlying inflation trend is weak, in our view.

Mixed messages on prices

The broader U.S. consumer price index (CPI) rose in December, buoyed by higher food and core goods prices. The consumer price gauge increased 0.4% from a month earlier and 1.4% from December 2019, according to the Labor Department. Still, the core inflation, which excludes volatile food and energy costs, remained tame and rose 0.1% from the prior month. Compared with a year earlier, the core CPI rose 1.6%.

The spread of Covid-19 had different effects on the components of the CPI basket. Food and core goods inflation rose with the pandemic and remain elevated; they are affected by supply distortions. Food consumption is price and income inelastic, and so the lower availability of food resources quickly found its way into prices.

A similar dynamic is playing out in core goods, but it is not uniform across the components. Consumers’ changing spending patterns, fiscal stimulus, and supply availability, which was more severe compared with food supply, all contributed by varying degrees.

Inflation chart

Compared with core goods inflation, core services inflation — which had been stable before the pandemic — has slowed since the pandemic began. Some of the drop is an indirect effect of energy prices. Prices for transportation services, for example, fell sharply early in the pandemic because of the plunge in airfares.

The Covid-19 pandemic has started a new trend in the housing market away from renters.

Shelter prices contribute to almost half of core inflation. Shelter inflation, which moves slowly by construction, fell from about 3.4% pre-Covid to 2.2% in December. There has been a notable deceleration in rental inflation. The pandemic has started a new trend in the housing market away from renters. Encouraged by low interest rates, households renting in crowded urban areas have rushed to buy single-unit houses in more isolated suburban areas.

While demand for single-units may decline, the rental market has to deal with a demand-supply imbalance. This is deflationary. And because of the way rental inflation is incorporated in the CPI basket, it takes time to see the actual deflationary effect on CPI inflation.

Labor market recovery will take time

As life normalizes with mass vaccinations, the labor market is likely to take longer to recover than GDP or economic activity. The pandemic increased labor and capital productivity. Higher productivity means better utilization of resources, which reduces the structural demand for labor. Some of the lost jobs won’t come back, and some of the temporary jobs created during the pandemic will be lost. Returning to pre-Covid-19 employment levels will take time. We expect this persistent slack to keep inflation low — and below pre-pandemic levels.

It is possible that some economic activity will overshoot during the transition phase from the pandemic to the post-Covid life. Leisure, entertainment, and other high-contact activities can surge as households readjust their lives and spending patterns. It is also possible that some of the earlier unspent checks and other fiscal stimulus will be used, adding to growth. Inflation can temporarily pick up during this high-growth phase if supply does not adjust at the same pace. We believe this is a risk, but not the base case.

Fed’s take on tapering and inflation

The Fed has indicated the possibility of a temporary spike in inflation during the transition phase to post-Covid life. When economic activity and inflation accelerate together, it may get harder to differentiate between the trend and the transition. Due to the uniqueness of this cycle, some central bankers may view it as a V-shaped recovery and conclude that it may be time to reduce monetary accommodation. This is one of the key risks for 2021, in our view, along with the virus and vaccine-related concerns.

When economic activity and inflation accelerate together, it may get harder to differentiate between the trend and the transition.

Some members of the Federal Open Market Committee (FOMC) have recently discussed the future of monetary stimulus. One might wonder if their comments have anything to do with the inflation trajectory. Income inequality worsened during the pandemic-induced recession. Low-income earners were significantly hit by the pandemic, but high-income earners mostly kept their jobs and benefitted from rising asset prices. This dynamic affected the housing market. The increase in home prices has caused a sharp drop in home affordability despite low interest rates, according to the Atlanta Fed’s Home Ownership Affordability Monitor index. In our opinion, home price inflation is becoming an issue.

Since early 2021, several Fed members have suggested the FOMC could begin gradually reducing asset purchases as soon as the second half of 2021. Although key FOMC members, including Fed Chair Jerome Powell and Vice Chair Richard Clarida, have moved to squash speculation about tapering, they did not take it off the table. Powell said during a press conference in January that the Fed isn’t close to countenancing tapering yet. Market participants view the Fed as being dovish on bond purchases. We believe they were not dovish enough.

If the economy outperforms the central bank’s expectations — which is likely in the second half of this year — there is a chance of a premature taper attempt.

The Fed remains concerned about the near-term outlook of the U.S. economy, but is more upbeat about the medium-term outlook. If the economy outperforms the central bank’s expectations — which is likely in the second half of this year — there is a chance of a premature taper attempt.

While we believe that tapering will not be as easy as it looks, we think it is becoming clear that the peak monetary stimulus is over. The near-term outlook may be weak, but as long as the medium-term outlook stays bright, we cannot totally dismiss the tapering narrative. The comments by several Fed members and other central bankers may have opened the Pandora’s box.

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