THE US Federal Reserve (Fed) has signalled it would tolerate faster inflation for a time to cement the post-pandemic recovery and boost employment, but the side effect is likely to be a faster rise in commodity prices.
The central bank appears anxious to avoid a repeat of the slow expansion and job gains that followed the financial crisis of 2008 by adopting a more aggressive approach to stimulating the recovery.
In March, non-farm employment was still down by more than eight million jobs compared with its pre-pandemic peak in February 2020, according to the US bureau of labour statistics, leaving a large jobs gap to be filled.
After its latest meeting on Wednesday, the Federal Open Market Committee confirmed it will seek to achieve the twin objectives of maximum employment and inflation at the rate of 2% over the longer run.
The committee noted price rises have been running persistently below target, so it aims to achieve inflation moderately above 2% for some time to make up the shortfall and anchor expectations at around the 2% level.
But if the Fed leaves rates low to target the slackest part of the economy – the labour market – it must intensify pressure on capacity and prices in other parts of the economy, including manufacturing and raw materials.
Proposals for medium-term inflation-averaging have been winning adherents for some years, but the committee appears to be planning something more ambitious – an attempt to engineer a job-creating boom.
The plan is to run the economy hot to achieve faster job gains, especially among disadvantaged groups that are marginally attached to the labour force, before shifting back to inflation control later in the cycle.
But the resulting pressure on global supply chains while the Fed pursues employment increases is likely to generate significantly quicker price rises for raw materials and a range of manufactured items.
Based on breakeven rates, bond traders are anticipating US consumer prices will rise at an average rate of 2.4% over the next ten years, compared with a realised average of 1.7% per year over the last decade.
For much of the last decade, expected inflation has been higher than the outturns, implying traders tend to overestimate price pressures.
But bond traders are probably correct for now, reacting to signs the Fed is prepared to tolerate significantly faster inflation to achieve faster employment gains.
Is there an undershoot?
In its statement, the Fed repeated its previous concerns about a persistent undershoot in the inflation rate, but there is no evidence for this, at least not since the middle of the last decade.
Price levels and inflation rates show no significant lasting impact from the coronavirus epidemic and recession in 2019, in contrast to the prolonged fall after the recession in 2008/09 and the mid-cycle slowdown in 2015/16.
Consumer prices have risen at an average rate of just over 2% per year over the last two years, three years and five years, according to the all-items consumer price index published by the bureau of labour statistics.
The only evidence for a persistent undershoot is the 1.7% increase over the last 10 years, influenced by unusually slow price increases between 2013 and early 2016.
Based on the all-items consumer price index, both the rate of inflation and the level of consumer prices are in line with their long-term trend, and there is no undershoot to make up.
The Fed prefers more specialised measures of inflation, including the deflator for personal consumption expenditures (PCE), which is part of the national income and product accounts.
PCE inflation has been running at 1.6%-1.8% per year over the last two, three and five-year periods, and as little as 1.5% over the last ten years, according to the US bureau of economic analysis.
But PCE inflation has been below 2% almost continuously since 2014, so if the Fed wants to make up for all that undershooting, it implies much faster price increases for an extended period.
Tight supply chains
The problem with the Fed’s new inflation averaging strategy is that it fails to specify the historical baseline from which deviations are being measured.
When exactly did consumer prices move below their desired level and how much of that deviation does the central bank want to reverse and over what time horizon?
The lack of clarity is probably intentional since it gives the central bank flexibility to interpret if the target has been achieved and when to start tapering its bond-buying programme and raising interest rates.
But the strategy strongly suggests the central bank has a relatively high tolerance for faster inflation at the moment and wants to allow the economy to run hot, creating lots of jobs, for a long period.
With the Fed focused on maximum employment creation, it is almost inevitable global supply chains and manufacturing systems will remain stretched, generating upward pressure on goods prices and raw materials.
Not since the 1960s has the Fed been so intensely focused on employment, when there was strong growth in output, but which eventually ended with a sharp acceleration in inflation at the end of the decade and in the 1970s.
For the central bank, the hope is that running the economy hot will encourage investment in additional capacity in the manufacturing and commodities sectors, creating jobs and dampening price increases over time.
There is a fine line between running hot and overheating, and if the central bank ends up on the wrong side, there will eventually have to be painful interest rate increases to tackle it.
In the meantime, high levels of consumer and business spending are likely to keep most commodities in short supply through 2021 and 2022, keeping upward pressure on raw materials and manufacturing prices. — Reuters
John Kemp is a Reuters market analyst. The views expressed are his own.