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An inflation test for the Fed

| October 9, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Consumer prices sank during pandemic lockdowns in the spring, and the Fed projected subdued inflation for years. But pandemic has produced anything but a garden-variety economy. Federal largesse has kept household spending up, and impediments to demand have come more from safety concerns and government-imposed restrictions than a soft economy. Prices have consequently rebounded in a way the Fed did not expect. Year-over-year headline and core inflation have already regained much of the ground lost in the spring, and it is certainly possible that inflation in 2021 will move well above 2%.

Breaking down the inflation data

Generally, prices sank in March and April when huge chunks of the economy shut down before beginning to rebound in May when economies started to reopen. Components of inflation changed significantly over the six months through August, the most recent data available (Exhibit 1).

Exhibit 1: PCE deflator inflation by category

Source: BEA.

Headline inflation dropped sharply in March and April, driven mainly by a steep fall in gasoline prices, and has rebounded over the following four months, again pushed up mostly by a bounce in prices at the pump. In fact, food prices mostly defied the pattern, rising during the lockdowns, when demand surged but supplier networks were stressed, and running steadier since May. Over the last six months, headline inflation has risen by 0.6%, an annualized pace of around 1.2%, as gasoline prices remain well below pre-pandemic levels.

Core inflation

Core inflation looks broadly similar to headline inflation over the past six months. Core prices fell in March and April by 0.5% combined but snapped back in the four months through August by 1.3%, an annualized pace of close to 4%. Over the 6-month period, the core PCE index rose by 0.8% or 1.6% annualized. The annualized pace since February is identical to the clip seen in the last six months before the pandemic.

Within the key categories, there are several themes, broadly hewing to the evolution of the economy. For some sectors, prices fell during the lockdowns and then rebounded once states allowed nonessential businesses to reopen and customers returned. New and used motor vehicle prices, household furnishings, and communications—mainly cell phone service contracts—all posted drops in March and April and rebounds since then. In particular, used vehicle prices have surged in recent months, as demand skyrocketed. Financial services show a similar pattern but for a different reason: the way financial services prices are calculated, they tend to be positively correlated to stock prices, so the swoon in equities in the early days of the pandemic and the rebound during the spring and summer were tracked by prices.

At the other extreme, there are services where demand has failed to rebound much, as lockdown restrictions remain in place, and prices have barely inched off the bottom. Airfares and hotels fall in that bucket. Apparel also shows that pattern, as work- and school-from-home rather than lockdown restrictions have limited the need for household spending on clothes.

There are other categories where demand remains restrained, but prices have been firm anyway. Restaurants, personal care services, and recreation services—including amusement parks, spectator events, and movie theaters—have seen relatively firm prices despite depressed levels of activity, perhaps reflecting capacity constraints imposed by local governments and cleaning costs. That explanation may also apply to the health care sector.

What it means and where we may be headed

Much as was the case with economic growth and the labor market, Fed officials during the early days of the pandemic missed by a mile in projecting inflation. Officials thought that it would take years to get anywhere close to the 2% target, as high unemployment restrained demand and led to soft prices. As it turns out, core inflation has already returned to close to a normal pace, after surging at a 4.5% annualized pace from June through August.

Presumably, the upward momentum will ease soon, as many sectors are getting back closer to normal. Industry data suggest, as an example, that used motor vehicle prices should continue to rise sharply for at least a few more months. Core inflation looks likely to moderate to something like a 0.2% a month over the balance of 2020, though given the last three readings, the risks may be to the upside. Such a result would push the year-over-year advance in the core PCE deflator, the Fed’s favorite measure of underlying inflation, to around 2% by the end of the year.

It is easy to foresee that when the two negative readings in March and April 2020 fall out of the 12-month window while the three high readings from June through August remain in, the year-over-year increase is likely to move well above 2%. Just doing the arithmetic, if core prices rise by exactly 0.2% every month, then the year-over-year core PCE deflator would shoot up to 3.0% in April 2021. However, Chicago Fed President Evans has already flagged that scenario, noting that the Fed’s “for a time” qualifier would not be triggered by the brief period of inflated readings coming next spring.

Beyond that, the outlook for inflation, as with the economy, will depend on the path of the virus. If the virus is brought under control in six months, allowing the economy to more completely return to normal, then demand may be robust and underlying inflation may remain firm. In contrast, if unemployment remains elevated, fiscal support wanes, and the economy becomes tepid next year, then inflation would presumably also be mild.

We know what the Fed will do in the latter scenario. The former scenario, however, could be interesting. If core inflation continues to run well above 2% by the end of next summer, by which time, the three elevated 2020 monthly readings will be out of the 12-month window, then the Fed’s new forward guidance could be tested years ahead of what the dot forecasts suggest the Fed expects.

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