U.S. consumers flush with cash could drive temporary inflation

Putnam Fixed Income team, 03/22/21

  • U.S. savings rates have spiked as consumers, forced into lockdown, scaled back their spending.
  • An easing pandemic and rising consumption will buoy growth, and potentially inflation, temporarily.
  • The Federal Reserve may taper asset purchases in 2022 if the economy overshoots.

The United States is facing an unusual combination of high household savings and a large government fiscal package. This is priming the economy for stronger growth this year. However, inflation can overshoot as the economy reopens.

Many Americans are flush with cash

As life returns to normal due to vaccinations and the economy fully reopens, economic activity and inflation can rise to unsustainably high levels. Inflation can overshoot if demand outstrips supply. Demand is likely to surge amid rising household incomes and historically high savings.

We identify two instances that can lead to temporary higher inflation. First, when a large share of personal disposable income comes from government aid programs (financed by debt and not taxes) and not from labor or capital income (which would increase output, or supply), higher demand may not be accompanied by an increase in supply. Second, households with unusually high levels of savings may find more ways to spend as mobility restrictions ease. If firms do not have large inventories to meet this demand, the demand and supply mismatch will be reflected in prices.

During the pandemic-induced recession, aggregate personal income in the United States dropped sharply, but disposable income, which includes government transfers such as stimulus checks and unemployment benefits, rose. This was unprecedented in U.S. history.

Inflation chart

In addition, the gap between consumption and income widened as households saved most of the government aid they received. The personal savings rate rose. As life starts to normalize, some of those "excess savings" will be converted to consumption. While we do not know how much of this money will be spent during reopening, it may add to growth and, potentially, inflation during the transition phase.

Upswing in prices

As we transition to post-Covid life, consumers are likely to revert to old spending patterns. We expect more demand for services like travel compared with goods. As such, the likelihood of an overshoot in services inflation is higher than for goods. Any mismatch between demand and supply can easily find its way into prices.

A large part of services in the U.S. CPI basket are housing related, and rental market dynamics mostly determine the path of core inflation. Even though inflation could surge in some high contact services activities during the transition phase, those activities have low weights in the CPI basket. The impact of so-called "pent-up demand" on CPI inflation is likely to be contained.

Over the past year, inflation has been tame. The U.S. consumer-price index increased at a seasonally adjusted 0.4% rate in February after rising 0.3% in January, according to the Labor Department. In the 12 months through February, the CPI gained 1.7%. The core price index, which excludes the often-volatile categories of food and energy, rose 0.1% in February from January, and was up 1.3% from the year prior.

Unless the virus or vaccinations take a turn for the worse, the U.S. economy is about to reopen. Households have large amounts of savings, and the economy is on the verge of accelerating in our view.

Will the Fed reverse asset purchase policy?

Congress approved President Joe Biden's sweeping $1.9 trillion rescue package in March. But we question whether the economy needs additional pandemic relief money at this point in the cycle after two previous fiscal packages and ample monetary stimulus. This is why the inflation debate is heating up.

The fiscal largesse needs to be reflected in U.S. Treasury yields and, hence, in asset prices. Treasury yields have spiked in anticipation of stronger economic growth this year and higher inflation. Until the Federal Reserve steps in, the inflation debate may not go away.

Biden's fiscal package will add to growth that is already underway. If the economy overshoots in line with our expectations, the Fed may consider that progress has been made toward full employment and price stability. In December, the central bank committed to continue buying bonds until there is "substantial further progress' toward those two goals. It is possible the Fed will announce plans to taper its asset purchasing program in late 2021 and begin the actual process in the first half of 2022.