Inflation Pressures Are Easing but Rate Cut Forecast Remains Uncertain

The New Year is beginning where the old one ended -- with uncertainty about when – or whether – the Federal Reserve will begin cutting interest rates.

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Judging by news reports and opinion pieces in trade publications and mainstream media, the risk of a housing bubble probably ranks as the top  concern of many economists and real estate industry executives today. But fear of resurgent inflation is a close second.  Home prices and a housing shortage are feeding the bubble fears, as we’ve discussed before; consumer prices and an increasingly rocky labor market recovery are creating the inflation jitters.

“Market worries surrounding high and accelerating inflation stem from the risk that pent-up demand, strong fiscal stimulus and the Fed’s commitment to keep policy rates on hold will cause overheating,” Moody’s Investor Service explained in a recent note to clients.

Recent economic reports seem to justify that concern. Consumer prices in the U.S. rose at the fastest pace in more than 12 years in April; worldwide, for the ‘group of 20’ leading economies, the annual inflation rate increased to 3.8 percent, up from 3.1 percent in March and the highest level for this indicator in more than a year.

 Compared with What?

While those statistics are unsettling, some analysts caution, ,they may not be definitive. The recent price increases reflect the economy’s recovery from the pandemic, while year-ago prices reflect the economic mess the pandemic was making. Then and now comparisons don’t necessarily reflect a current trend.   

When “something screwy” happens in the base year, a Wall Street Journal article explained, the year-to-year comparison will be “distorted.”   The upward trend in consumer prices evident in recent reports reflects the sudden surge in demand that has followed the easing of pandemic restrictions, and the supply chain bottlenecks and materials shortages resulting from that rebound.  While those problems have been significant, analysts agree, they are likely to be temporary.   

Analysts who downplay inflation risks also say the concerns are based  in part on the experience of the 1970s, when rising consumer prices triggered demands for higher wages which in turn sparked higher prices, producing a damaging inflationary spiral. 

“Many people are making the comparison with the 1970s, but the world is very different,” Laurence Boone, the chief economist for the Organization for Economic Co-operation and Development (OECD) told the WSJ. “We’re more open, we don’t have the same level of unionization and indexation, and the demographics are different.”

Theory vs. Reality

While economic theory may suggest that inflation fears are overstated, on-the-ground experience suggests otherwise to some business executives.  In an interview with CNBC, Costco CFO Richard Galanti, pointed to “higher labor costs, higher freight costs, higher transportation demand…container shortages and port delays … increased demand [for various products] and  various shortages of everything from chips to oils and chemical supplies….” as evidence that inflation isn’t just a theoretical concern. It’s a serious and growing problem creating significant inflation risks.

Against the backdrop of this debate over whether inflation is a threat to be combatted or a temporary glitch to be ignored, the Federal Reserve is pondering when to begin scaling back the easy-money policies holding interest rates near zero to insulate the economy from the pandemic’s worse effects.

“Whiplash” Employment Reports

Employment, one of the indicators Fed analysts are watching most closely, has given them whiplash in recent months. Employers added only 266,000 jobs in March, about one-quarter of the nearly one million jobs economists had predicted following February’s  gangbuster labor market report. 

Political reverberations came quickly, with critics of the Biden Administration’s stimulus plan blaming generous federal unemployment assistance for leading some workers to conclude that they could earn as much, if not more, by staying home than by returning to old jobs or accepting new ones.  Supporters of the Biden plan, on the other hand, cited the sluggish employment numbers as evidence that the recovery is slowing, indicating a need for continuing government aid.

The May employment statistics brought a measure of relief to Fed policy makers trying to navigate a path through these conflicting theories. Employers added 559,000 workers to their payrolls in May – a strong enough performance to ease concerns that the recovery is faltering, but not strong enough to justify Fed action to cool inflationary heat.

Fed’s Dilemma

The minutes of the April meeting of the Federal Open Market Committee (FOMC), the Fed’s policy making arm, indicated for the first time that some Fed governors were contemplating the need to scale back or eliminate the Fed’s purchase of mortgage and treasury bonds in order to boost interest rates and reduce inflation risks.  But for now, at least, it seems that the majority of Fed Governors are inclined to be patient.  The risks of derailing the recovery by booting interest rates prematurely, in their view, outweigh the risks of triggering inflation by leaving rates too low for too long.

In recent Congressional testimony, Fed. Gov, Randal Quarles said the consensus view of Fed analysts is that recent increases in consumer prices and other inflationary indicators, while “significant’ are probably “temporary.”  The Fed is prepared to act if inflationary risks become clear, he said, “but I do think that if we were to try now to stay ahead of the inflation curve we could end up significantly constraining the recovery.”

Carl Tannenbaum, chief economist for Northern Bank, agrees that inflation concerns shouldn’t drive the Fed’s policy decisions, at least, not now.  “I subscribe to the thesis that a great deal of what we are seeing now is not going to change the trajectory of long-term inflation,” he told the Wall Street Journal.  “But it isn’t easy to get a firm fix on long-run inflation at the moment,” he cautioned.  “And the potential for policy error is high.”