As Inflation Takes Center Stage, What Role Will The Fed Play?

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In response to the economic impact of the coronavirus pandemic, global governments have embarked on a massive spending spree that has pushed total debt to GDP ratios from 88% to a staggering 105% (according to the Institute of International Finance). The U.S. Treasury has been front and center in this initiative as domestic national debt rose from an already alarming $23 trillion to a current level of $29 trillion.

The purpose of this increased borrowing and spending was to take the edge off the resultant recession and provide a cushion for those most affected by the slowdowns. Artificially propping up demand with government spending in times of crisis is basic Keynesian theory, and its efficacy is agreed upon by many economists, provided it’s used with discipline and for short periods of time. Those same economists would probably have a spirited debate as to the definition of “short term” and whether 18 months and counting falls under that.

But does this spending come without a cost? Some traditional inflation indicators, like the Producer Price Index and raw commodity prices, have been flashing a warning for months that inflation is taking root. The Federal Reserve has repeatedly stated that the inflation is transitory, but as time passes, many believe that this may not be true.

There are a couple things that make the current situation unique. The same economic crises and pandemic fears that caused the government’s spending spree have also caused global supply chain disruptions that have made a multitude of products and raw materials much more scarce. It’s no surprise that government-fueled demand, coupled with a significant decrease in supplies, has caused inflation. The supply versus demand equation and its effect on inflation is one of the few things that is considered “settled science” in the economic world.

Secondly, the Federal Reserve has played a significant role in the government’s spending spree. On March 23, 2020, the Fed announced a huge increase in its asset purchase program known as quantitative easing. This was done to facilitate the Treasury’s debt issuance and keep interest rates from moving significantly higher under the anticipated increase in the amount of bonds to be sold by the U.S. Treasury. All these emergency economic measures were taken under the belief that they were both necessary and, more importantly, temporary. A common belief now is that the clock is ticking and that normalization of policy must come soon or else it could lead to uncontrollable inflation.

CME Group Senior Economist Erik Norland seems optimistic that increased vaccination rates will play a significant role in distancing us from the pandemic and the consequent emergency spending levels and aggressive Fed policy. This, combined with additional tax revenue, had Norland conclude that “it looks like government deficits will begin to shrink going forward.” Norland also believes that the Fed may begin to taper asset purchases soon, and that could allow long-end rates to rise. “In 2013, when the Fed tapered, it caused a huge bear market in bonds, and 10-Year yields went from 1.4% to north of 3%,” said Norland.

There’s little question that rising rates, increased taxes and less government spending could help to slow inflation. But will it be enough? Dan Deming, managing director at KKM Financial, believes that inflation could remain an issue as “supply chains continue to be a challenge” and that “the current flattening of the yield curve could be a signal that growth prospects are under pressure” due, in part, to those supply shortages.

The inflation debate seems to have three moving parts that will be watched closely by traders going forward: the size of a new government spending package being debated in Washington, D.C.; the Fed’s timeline for tapering; and proposals for tax increases going forward.

Watch our full OpenMarkets Roundtable discussion on central bank policy paths above. Watch other episodes here.

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