MNI INTERVIEW: Market Right to Fear Inflation-Ex-Fed Economist

Wall Street's growing concern over the prospect of higher U.S. inflation is warranted given the combination of super-loose monetary policy and a highly proactive fiscal policy that could make future increases in interest rates much more difficult, former St. Louis Fed economist William Gavin told MNI in an interview.

"The fear of inflation is healthy," said Gavin. "It's the underlying lack of budget discipline combined with a Fed that won't fight it that should worry markets."

The prospect of another large fiscal stimulus from President Joe Biden and the Democratic-led Congress after an initial USD1.9 trillion proposal has supercharged the debate over inflation, with even deficit doves like ex-Treasury Secretary Lawrence Summers voicing concern about possible overheating.

"I think what's going to happen is there's going to be some landmark situation in which the Fed caves to Biden and Yellen and the market loses its faith," said Gavin, who was also an ex-senior policy adviser at the regional central bank and spent many years at the Cleveland Fed. He retired from the St. Louis Fed in 2014.

FALSE SENSE OF COMFORT

Gavin is worried that the low inflation period of the last two decades has lulled policy makers into a false sense of comfort that leaves them vulnerable to future price shocks, particularly in the wake of a pandemic with highly uncertain economic implications. He and others believe the large fiscal response to the pandemic could tie the Fed's hand's on inflation because any hike in interest rates would sharply raise debt burden costs.

Ten-year Treasury yields this week spiked to their highest levels since the start of the Covid-19 pandemic, and policy makers are trying to discern hopes for stronger growth from fears of higher inflation.

"What happens once inflation starts to go up and the Fed doesn't respond or responds very weakly? Nobody in these markets has any experience with inflation."

U.S. inflation has been running at just above half the Fed's 2% target, and remained below the central bank's official goal for most of the recovery from the Great Recession.

The Fed last year revised its policy framework and offered new forward guidance on interest rates to make clear it wants to overshoot inflation for a time to make up for past losses. Since the start of the pandemic, it has not only kept interest rates at zero but also bought USD120 billion in bonds per month and plans to keep doing so with no plans to reduce that pace in sight.

FINE TUNING MAY BE TOUGH

Gavin said fine tuning in response to any resurgence by consumer prices may be too difficult to accomplish, although he declined to specify how likely inflation is likely to go or when a sustained spike might begin.

Fed officials are braced for what they say are likely to be temporary inflation spikes this year linked to pandemic disruption effects on the data, but are on guard for possible signs of persistence given newfound supply constraints.

"I do think when it happens it's going to be ugly and it's going to happen faster than people expect," he said.

Minutes from the Fed's January minutes described the inflation outlook "as having become more balanced than was the case over most of 2020, although most still viewed the risks as weighted to the downside."

Still, the report added that "as an upside risk to inflation, several participants noted the potential for pandemic-related supply constraints to affect price inflation somewhat more than anticipated or for price increases among industries most adversely affected by the pandemic to be more pronounced than projected."