INTERVIEW: Inflation Risks Mount, St Louis Fed Economist Says

The Federal Reserve must watch inflation closely as the pandemic eases to ensure an expected spike later this year does not become a more permanent feature of a post-Covid economy reliant on surging public borrowing, St. Louis Fed economist and senior vice president David Andolfatto told MNI.

In one of the starkest warnings of inflation danger yet from inside the Fed since massive monetary and fiscal support was deployed during the Covid pandemic, Andolfatto said the economy's spare capacity may be much smaller than generally believed, meaning additional government spending and bond issuance could generate inflation sooner than forecasters expect.

Rocketing Treasury issuance and a declining commitment to rein in deficits over the longer term was a potentially combustible combination, he said in an interview.

"I don't see how we can not get inflation because of the (declining) political will to kind of anchor the fiscal side," Andolfatto said. "I don't believe in free lunches. At some point it's got to come."

Inflation is likely to spike above the Fed's target later in the year, "not tremendously, maybe 2.5%," Andolfatto said. "The big question is whether that spike is temporary or persistent."

His own assessment of the economy points to at least a significant risk of the latter.

"I argue that we are quite close to capacity--the output gap is not very big," he said. "Normally, when you have clear evidence in excess capacity, like in the financial crisis … you'd expect the pressure of this additional debt issuance to be absorbed largely through an increase in real economic activity. But if you're at or near capacity you can probably expect the pressure to be released along other dimensions--of prices."

FISCAL HARPOON

Having undershot its 2% target for the decade following the Great Recession of 2007-2009, the Fed became more sanguine about the prospect of high inflation--and about the limits of its balance sheet, which has ballooned to over USD7.4 trillion today from just above USD4 trillion at the start of the pandemic.

The Fed has been buying USD120 billion a month in Treasury bonds and mortgage-backed securities since March, and has signaled it will keep doing so until policy makers see "substantial further progress" toward full employment and stable prices.

Calls have also grown for greater emphasis on deficit-financed fiscal policy, with proponents, including Treasury Secretary Janet Yellen, arguing that low interest rates make it logical to 'go big' in borrowing to finance a strong recovery.

Worries have risen on Wall Street, however, that an extended period of very low interest rates combined with heavy Fed bond buying and proactive fiscal policy might finally generate the inflation bump that has proven so elusive--not just in the U.S. but in most rich countries--in the 21st century.

"I think it would actually manifest itself in inflation at some point," said Andolfatto. "Then the question is not so much that because a little bit of inflation is not a big deal. The thing that concerns some people is whether or not this event would occur suddenly."

LACK OF SLACK

Uncertainty over the amount of slack in the economy makes such a swift shift more likely. Market expectations for inflation five years out have ticked higher, albeit to still moderate levels just above 2%.

The Fed's preferred inflation measure, the personal consumption expenditures index, remains well below target at just above 1%. MNI reported last week that the Fed is unlikely to consider hiking rates until FOMC members' quarterly projections point to consistently above-target inflation.

Fed officials have consistently argued that, given their inability to push interest rates below zero, they will have an easier time tightening policy than loosening. But timing is everything--and the Fed's revised framework and forward guidance on rates both emphasize making up for past inflation and employment shortfalls, potentially curbing the central bank's ability to shift gears quickly.

"It would be easier if at the Fed you kind of saw long yields kind of creep up and break-evens kind of creep up slowly and then it's kind of manageable we can see it happening and we can kind of get ahead of the curve a bit," said Andolfatto. "But what happens if it's just a sudden stop? I don't know what would trigger that but as policy makers or central bankers you have to ask what if and what would you do in that case."