October 1, 2021
There are many different measures of inflation, but the one that the Federal Reserve considers to be most important is the personal consumption expenditures deflator, in particular the PCE deflator excluding the volatile food and energy components.
The PCE deflator climbed by 0.4% in both July and August. The year-over-year increase now stands at 4.3%.
Excluding the volatile food and energy components the PCE deflator rose 0.3% in both July and August. The year-over-year increase is now 3.6%. This is the inflation measure that the Fed would like to see rise by 2.0%. Clearly these recent larger-than-expected gains reflect jumps in airfares, hotel room rates, and restaurant prices as the economy re-opens and those prices rebound from recession-led declines. The Fed is convinced that those price gains will be temporary. We are not so sure.
The purchases of Treasury securities by the Fed lasts year has caused money supply growth to surge. We all learned back in our basic economic classes that money growth is the cause of inflation. However, the length of time between a pickup in money growth and an increase in inflation is both long and variable. Thus, the recent increase in money growth should cause the inflation rate to climb above the Fed’s 2.0% target not just for a couple of months but for a protracted period of time.
For what it is worth, we expect the core PCE deflator to increase from 1.5% in 2020 to 4.5% in 2021, and 3.9% in 2022. The Fed welcomes a somewhat higher inflation for a period of time to make up for the fact that the PCE deflator rose about 0.5% less than the Fed’s 2.0% target for a decade. Keep an eye on inflation expectations. If they begin to climb at a 3.0% mark or above, the Fed may begin to shift to a slightly less generous monetary policy. But the first step will be to reduce their monthly purchases of $120 billion of U.S. government and mortgage-backed securities. That process might begin in December of the first part of next year and be completed by mid-2022. Only then will they consider an increase in interest rates which now seems likely to occur sometime in late 2022 or early 2023.
We expect third quarter GDP growth rate of 8.0%. We also look for 7.8% GDP growth for 2021 as a whole and growth of 5.1% in 2022 as more workers become available and as supply bottlenecks are reduced.