Inflation watch is on, but the Fed isn't biting

One week after the new stimulus bill has been signed into law, with checks already being deposited into tens of millions of Americans' accounts, the bond markets have reacted to all this money being pumped out.

But the short-term rates have not risen, and the Federal Reserve's Open Markets Committee said this week that it’ll keep the money flowing for the near future.

The median member of the FOMC still forecasts no liftoff from near-zero rates through the end of 2023, the same as Fed forecasts from December. Three months ago, five Fed officials saw at least one rate hike over that time horizon. But in this week’s release, seven (of 18) officials now see at least one rate hike.

In its updated Summary of Economic Projections, the FOMC now expects the unemployment rate to tilt down to 4.5% by the end of this year with inflation reaching 2.2%. Three months ago, the Fed expected an unemployment rate of 5.0% by the end of 2021 with inflation missing 2% until 2023.

The Fed reiterated that it is still waiting to see “substantial further progress” toward its dual mandate goals of maximum employment and stable prices before it pulls back on its quantitative easing program. The central bank maintained its commitment to purchase at least $120 billion a month in U.S. Treasuries and agency mortgage-backed securities.

The FOMC has also made it clear that it will not consider a rate hike until inflation (measured in core personal consumption expenditures) reaches 2% and shows signs of “moderately” overshooting that target for some time.

The “for some time” part of the equation is important because we will see some high year-over-year inflation numbers starting next month, as the lockdown-based deflation of prices comes off that 12-month clock.

So even if we get tepid increases of 0.2% in each of the next 2 months, the year-over-year amount will be at or above 3%, and I’d imagine there would be more voices asking for rate hikes (or at least fewer asset purchases) when that happens.

The other reason there may be talk of inflation is that it is costing businesses more in recent months to make products and provide services, especially in recent months.

The Producer Price Index for final demand increased 0.5 percent in February, seasonally adjusted, the U.S. Bureau of Labor Statistics reported today. This rise followed advances of 1.3 percent in January and 0.3 percent in December. (See table A.) On an unadjusted basis, the final demand index moved up 2.8 percent for the 12 months ended in February, the largest increase since rising 3.1 percent for the 12 months ended October 2018.

Most of the February advance in prices for final demand can be traced to a 1.4-percent rise in the index for final demand goods. Prices for final demand services increased 0.1 percent.

Prices for final demand less foods, energy, and trade services moved up 0.2 percent in February, the tenth consecutive advance. For the 12 months ended in February, the index for final demand less foods, energy, and trade services rose 2.2 percent, the largest increase since a 2.4-percent advance for the 12 months ended May 2019.

It’s even higher before you get to the final product, which will likely raise costs and/or reduce profit margins as it moves further down the supply chain.

Much of this traces back to higher oil/gasoline prices in 2021 and other speculation in commodity markets. But those might be on the way down as oil is back down below $60 a barrel after dropping more than $5 on Thursday. And the runup in ag products like soybeans has leveled off in recent months.

In addition, the prices on soybeans futures drop from nearly 1400 to 1200 between May and November, meaning that traders are counting on this short run of inflation to end and go back to 2020 prices.

These reasons are likely why the Fed is waiting for US unemployment to drop further and stay down for several months before they start to tighten money, instead of reacting to the temporarily rising prices and longer-term interest rates. And that's the right response, as any change in interest rates will likely lead to a panic from Wall Streeters who see the cocaine party ending in our still-shaky economy, which could well re-start the cycle of layoffs and stagnate our recovery before we get back to anything close to pre-COVID normal.