By Varshika Prasanna
As the pandemic pushed the global economy into a recession, inflation rates are at a decade low and are well below the Fed’s target of 2%. However, the markets are anxious about inflation as President Biden announced his plans for the fiscal stimulus.
In the short term, decades of habits are likely to keep inflation low. To revive the economy after the COVID-19 pandemic, the Fed would encourage inflation to overshoot the target. In the long term, economists and investors foresee that a shifting political climate will help push inflation well past 2%; the fiscal stimulus post COVID-19 as well as prioritising goals like narrowing racial and economic disparities may put inflation at the back-burner of policy makers.
The pandemic has certainly complicated the inflation picture. Before the pandemic, the prices for gasoline, lodging and airfare helped inflation rates reach 2.3% in February 2020. As the prices for the aforementioned goods and services have since crashed, inflation went down to 1.4% this January.
Economists project that the fiscal and monetary stimuli in combination with vaccination should help increase economic output. Brookings Institution projects that GDP will increase up to 7.8% this year. However, whether this growth will affect inflation is questionable, as in the past, inflation has run close to 2% even with soaring GDP growth rates and low levels of unemployment.
If inflation is consistently below 2%, it leaves very little room to withstand recessions. To prevent this, the FED announced that it would seek to push inflation over 2% so that over time, both inflation and inflation expectations average out to 2%. President Biden’s stimulus helps this cause. Some economists argue that Biden’s stimulus is so large that it might push inflation to rate much higher than intended. On the other hand, some predict that due to social distancing measures, it will be difficult for households to spend the money, and hence the multiplier will be less than 1. Olivia Blanchard, former chief economist at the International Monetary Fund, said that the multiplier could be much more considering the fact that the stimulus favors low income families, who tend to spend most of their income.
The Fed and Jerome Powell have recently stated that they do not have any plans to increase interest rates until inflation reaches 2%. Investors are now worried, as if the Fed continues to keep interest rates near zero for too long, it will ultimately have to hike up the interest rates to avoid inflation. This is causing anxiety in the markets, as high inflation rates will make it that much harder to bring prices back under control. The steep rise in inflation rates combined with a weak economy just recovering from the impact of the coronavirus paints a terrifying picture for the stock market. A company’s stock price is based on how much the company’s future cash flows are worth today. As inflation rates increase, the discount rate also increases, thereby decreasing the present value of a company’s future cash flows. Similarly when the economy is weak, investors might choose to hedge their investments and go for securities that are less riskier than stocks. Hence, investors are flocking to purchase bonds, although they have a lower yield, in fear of a stock market crash; this has led to a bond market boom in the recent days.
Bond yields have risen ever since Democrats won Senate control in anticipation of a fiscal stimulus which would lead to more growth and thereby higher inflation. According to regular and inflation protected treasury bonds, the expected inflation in the next five years is around 2.39%. Investors’ expectations about inflation can be seen in the difference between yields on ordinary treasury bonds and yields on TIPS (inflation protected treasury bonds). This difference between the two is known as the break-even rate. The short term break-even rates are higher than the long term break-even rates, creating an extremely rare situation known as inversion of the break even curve as it predicts a surge in inflation rates that soon drops. Long term inflation expectations are lower- 10 year break even rates are 2.15% and 30 year break even rates are 2.1%.
Some believe that President Biden’s Fiscal Stimulus will only provide benefits in the short term and as a result the rise in inflation will only be short lived. Another opinion is that the Fed, despite promises otherwise, will cap inflation at 2%. This theory is supported by the yields on 10 year TIPS which have risen over the past few weeks causing the break even rate to fall. According to David Riley, an investment strategist at BlueBay Asset Management, a situation like this occurs when either growth looks weak or under the threat of a possible rise in interest rates by the Fed. Since the former is unlikely, the latter seems more plausible. An alternate opinion is that the market is underpricing the impact of the fiscal stimulus. However, there is apprehension that rising interest rates in a world already saddled with debt will cause households to divert more income to debt repayment, which will not fuel economic growth.
Thus, the inflation situation in the US is precarious. Policy makers must carefully consider the implications for allowing inflation rates to increase as the economy grows out of the COVID-19 recession. However, if the Fed chooses to stick to its 2% target, it might push the economy a little too close to deflation, where the price levels continually decrease. Prolonged deflation can throw the economy into a recessionary spiral, with aggregate demand so low that it will become very difficult for policymakers and the Fed to bring the economy back. □
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