How the Fed Will Respond to the Coming Inflation Scare
Comment of the Day

December 30 2020

Commentary by Eoin Treacy

How the Fed Will Respond to the Coming Inflation Scare

This article by Tim Duy for Bloomberg may be of interest to subscribers. Here is a question:

For an example of how the economy might recover faster than expected, consider that the consensus estimate for fourth-quarter growth is just under 4% while the Atlanta Fed’s GDPNow current estimate is 10.4%. Although the fourth quarter might not turn out to be quite so rosy given rising Covid-19 cases, the Atlanta Fed number still illustrates the possibility of some very good outcomes for the economy. For another example, consider that the $900 billion fiscal package is about 4.5% of GDP, or just about the size of the output gap. Imagine the possibility of being on the edge of full capacity already when the vaccine has been sufficiently distributed to allow the resumption of normal activities.

To be sure, any estimates of the output or unemployment gaps are just that — estimates. They will raise some worries about reports showing higher rates of inflation yet still leave the Fed hesitant to change the expected path of rate increases. The Fed will believe the economy is operating closer to full capacity if wage growth accelerates meaningfully beyond the 3.5% seen in July 2019, the high of the last cycle. That would help the clear the way to higher interest rates

​My instinct is that getting all three of these pieces to come together makes inflation more of a 2022 story than a 2021 story. At this point, the 2021 story still looks less like real inflation and more like an inflation scare. And with its new policy strategy, the Fed won’t scare easily.

Eoin Treacy's view

The rebound from a large decline will always have the benefit of a base effect. A decline of 20% requires a rebound of 25% to get back to even. When that occurs in a short period of time it looks like a big move and it affects sentiment. 2021 is going to be a year of reflation because economic contractions are already being repaired as vaccines are rolled out. The rising number of cases at present are as much to do with the higher transmissibility of the new strain as they are about the impatience of consumers to get back to life as normal. That suggests plenty of scope for higher consumption.

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