Fed officials see greater risk to US economy from low inflation

Federal Reserve officials generally believe the threat posed by subdued inflation is greater than the danger of rapidly rising prices, as they begin to factor in the possible effect of President Joe Biden’s $1.9tn fiscal stimulus.

The US central bank held an extensive discussion of inflationary trends last month in light of a possible acceleration in the economic recovery this year triggered by Biden’s stimulus package, according to minutes from the January meeting of the Federal Open Market Committee.

“Participants generally viewed the risks to the outlook for inflation as having become more balanced than was the case over most of 2020, although most still viewed the risks as weighted to the downside,” the FOMC minutes said.

America’s top central bankers are not expecting a sustained jump in prices, a view conveyed by Jay Powell, the Fed chairman, in a speech last week.

While prices were expected to move higher, they were expected to do so “along a trajectory consistent with achieving the Committee’s objectives over time, supported by stronger economic activity, widespread vaccinations and the associated reduction in social distancing, and accommodative fiscal and monetary policy”.

The Fed has dismissed concerns about unhealthy jumps in inflation this year due to Biden’s stimulus — which have been raised by economists like Lawrence Summers, the former Treasury secretary — partly because it remains wary of the economy’s health.

“Many participants remarked that the pandemic continued to pose considerable risks to the economic outlook, including risks associated with new virus strains, potential public resistance to vaccination, and potential difficulties in the production and distribution of vaccines,” according to the minutes.

A few Fed officials “pointed to the possibility that fiscal policy could turn out to be more expansionary than anticipated, that households could display greater willingness to spend out of accumulated savings than expected, or that widespread vaccinations and easing of social distancing could result in a more rapid boost to spending and employment than anticipated”.

While several participants in the meeting pointed to possible “pandemic-related supply constraints to affect price inflation”, many acknowledged the need to differentiate between temporary bursts in inflationary pressures, versus something more sustained.

“Participants emphasised that it was important to abstract from temporary factors affecting inflation — such as low past levels of prices dropping out of measures of annual price changes or relative price increases in some sectors brought about by supply constraints or disruptions — in judging whether inflation was on track to moderately exceed 2 per cent for some time,” the minutes said.

Investors have already begun to price in higher inflation, in anticipation of a robust economic rebound later this year.

US government bonds have sold off sharply in recent weeks, sending yields, which rise as prices fall, surging higher. The benchmark 10-year note now trades at its highest point in roughly one year, at nearly 1.3 per cent.

Inflation expectations have also ticked higher. One metric derived from US inflation-protected securities, the 10-year break-even rate, has soared from roughly 1.9 per cent at the end of December to 2.2 per cent — a level last reached in 2014. 

James Sweeney, chief investment officer for the Americas at Credit Suisse, said the Fed’s acknowledgment in the minutes about the prospects of higher inflation was appropriate, especially given the fact that inflation risks have risen in recent weeks.

“I’m not forecasting very high inflation . . . but I do think that everything that would make me expect an inflation scare is in place in the next 3-6 months,” he said.

Biden’s stimulus plan has yet to pass Congress. A final version is likely to include direct payments to individuals, an extension of unemployment benefits and aid to state and local governments. On Tuesday night in Wisconsin, Biden said it would help the US economy come “roaring back”.

Also on Wednesday, the Fed flagged the recent drop in short-term interest rates and highlighted the tools at its disposable to ensure its policy rate trades within its target band of 0 to 0.25 per cent — including adjusting the interest it pays banks on reserves they hold at the Fed, or the IOER rate.

Since the start of the year, the cost of borrowing cash in the repo market, where investors swap high-quality collateral like US Treasuries, has slipped from about 0.1 per cent to 0.06 per cent. Meanwhile, yields on Treasury bills, which mature in one year or less, now sit close to zero.