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Inflation Won’t Force The Fed To Tighten in 2021

Monetary Policy in the United States is extraordinarily loose.  The Federal Funds Rate is very close to 0% and the Fed is creating $120 billion a month through Quantitative Easing.  This extremely loose Monetary Policy is very supportive for asset prices, which are moving up across the board.

Moreover, the US economic outlook for 2021 appears bright.  With vaccines rolling out quickly now, there is reason for optimism that, by the third quarter, the Covid pandemic will have been brought largely under control and life will have begun to return to normal. Saving rates are already high due to past government fiscal support measures, and a new $1.9 trillion stimulus bill is likely to be passed by Congress soon.  People are going to want to go out and spend.

However, will that spending drive up inflation and force the Fed to tighten Monetary Policy?  The answer to that question is enormously important because when the Fed does signal that it intends to tighten, the financial markets are likely to experience a significant correction.

Commodity prices have already begun to move up rapidly.  The Bloomberg Commodity Price Index is up 13% year on year. Given aggressive government stimulus and pent-up demand, it is quite likely that Commodity Prices will continue to move considerably higher during the next several months.

A large increase in Commodity Prices, by itself, is not going to force the Fed to tighten Monetary Policy, however.  That is because movements in Commodity Prices have only a limited impact on the measure of Inflation that the Fed watches most closely.

The Core Personal Consumption Expenditure Price Index (Core PCE), which excludes movements in food and energy prices, is the Fed’s preferred measure of Inflation.

The Fed tends to disregard changes in Commodity Prices because they are highly volatile.  On the other hand, the Fed watches wage inflation very carefully.  That is because when wages begin moving up rapidly that tends to push up the cost of all other goods and services, creating the possibility of a “wage-push inflation” spiral that could become difficult for the Fed to contain.

The high level of unemployment in the country makes a substantial increase in wages highly unlikely this year.  Furthermore, even if Core PCE Inflation did move meaningfully above 2% later this year, in light of the Fed’s recently revised policy of targeting 2% inflation on average over the long run, it is unlikely that the Fed would tighten Monetary Policy given how long inflation has undershot the Fed’s inflation target. 

Therefore, the Fed is likely to hold the Federal Funds Rate very close to 0% and continue creating $120 billion (or more) every month for the rest of this year, just as they have been telling us they will do in speech after speech for the last many months.

The Financial Markets love liquidity but are also subject to fits of nervousness.  As evidence of mounting inflationary pressure builds during the months ahead, as it inevitably will, it is quite possible that investors will lose their nerve a time or two before 2022 arrives.  Therefore, rising – but volatile – markets seem to be the most likely scenario for the foreseeable future.

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