How the Fed will respond to the coming inflation scare

Don't expect the Federal Reserve to tighten monetary policy in 2021- even if inflation comes in higher than central bankers are forecasting. Tim Duy Opinion Save Share 1/4/2021 How the Fed will respond to the coming inflation scare https://www.afr.com/policy/economy/how-the-fed-will-respond-to-the-coming-inflation-scare-20201231-p56qyg 2/8 saving. The newly announced $US900 billion ($1.2 billion) fiscal aid package is the icing on the cake as it will leave the economy on firmer footing from which to launch in the spring. It is not hard to imagine that at some point next year reports will show the rate of inflation rising above the Fed's 2 per cent target. Considering the lost travel and dining opportunities this year, the greatest pent-up demand is likely in the leisure and hospitality sector. Yet that same sector has also suffered some of the greatest supply disruptions due to closures and laid-off workers. It is reasonable to expect that the surviving companies will have stronger pricing power. RELATED How free money will remake the economy RELATED Australia's trillion-dollar man is calm about debt While faster inflation might rattle some market participants, the Fed will likely remain calm. During the press conference that followed the December Federal Open Market Committee meeting, Fed chairman Jerome Powell said the central bank would tend to view such inflation as the result of one-time price changes rather than the beginning of a sustained inflationary process that forces policy makers to take action. They view these kind of price shocks as having transitory impacts on inflation. It's hard to see how we get interesting inflation numbers that are concerning in the face of excess capacity in the economy. The output gap, or the difference between where they economy is and where it should be, was likely around 5 per cent of gross domestic product going into the fourth quarter. The unemployment gap, or the difference between unemployment and the natural 1/4/2021 How the Fed will respond to the coming inflation scare https://www.afr.com/policy/economy/how-the-fed-will-respond-to-the-coming-inflation-scare-20201231-p56qyg 3/8 rate of unemployment (around 4.1 percentage points according to the median FOMC projection) was 2.6 percentage points in November. Even so, how fast those gaps disappear will influence the Fed's reaction to any high inflation numbers that pop up next year. That means the inflation question is not about inflation alone, but inflation combined with how quickly the economy recovers. The risk for the interest rate outlook is that the economy recovers to full capacity operating levels faster than policy makers or market participants expect. RELATED US emplo US emplo US emplo US emplo US employyyyyers added 245,000 jobs in N ers added 245,000 jobs in N ers added 245,000 jobs in N ers added 245,000 jobs in N ers added 245,000 jobs in Nooooovvvvvemb emb emb emb embererererer, mis , mis , mis , mis , missing sing sing sing sing eexpectations RELATED FFFFFed v ed v ed v ed v ed vooooowwwwws to buy b s to buy b s to buy b s to buy b s to buy bonds for some time y onds for some time y onds for some time y onds for some time y onds for some time yetetetetet For an example of how the economy might recover faster than expected, consider that the consensus estimate for fourth-quarter growth is just under 4 per cent while the Atlanta Fed's GDPNow current estimate is 10.4 per cent. Although the fourth quarter might not turn out to be quite so rosy given rising COVID-19 cases, the Atlanta Fed number still illustrates the possibility of some very good outcomes for the economy. For another example, consider that the $US900 billion fiscal package is about 4.5 per cent of GDP, or just about the size of the output gap. Imagine the possibility of being on the edge of full capacity already when the vaccine has been sufficiently distributed to allow the resumption of normal activities. To be sure, any estimates of the output or unemployment gaps are just that - estimates. They will raise some worries about reports showing higher rates of inflation yet still leave the Fed hesitant to change the expected path of rate increases. The Fed will believe the economy is operating closer to full capacity if wage growth accelerates meaningfully beyond the 3.5 per cent seen in July 2019, the high of the last cycle. That would help the clear the way to higher interest rates. 1/4/2021 How the Fed will respond to the coming inflation scare https://www.afr.com/policy/economy/how-the-fed-will-respond-to-the-coming-inflation-scare-20201231-p56qyg 4/8 My instinct is that getting all three of these pieces to come together makes inflation more of a 2022 story than a 2021 story. At this point, the 2021 story still looks less like real inflation and more like an inflation scare. And with its new policy strategy, the Fed won't scare easily. Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon. Washington Post

READ THE ABOVE ARTICLE AND ANSWER THE QUESTIONS:

In an Australian Financial Review article, Professor Tim Duy from the University of Oregon asserts that there are many factors that might increase the US inflation in 2021, such as consumer confidence following the Covid vaccine. However, he also argues that the US Federal Reserve Bank (the Fed) is not likely to tighten monetary policy in 2021.

1.What were his arguments for a high expected inflation rate in the US in 2021?

2.Why did he think the Fed would not likely tighten monetary policy in 2021?

3.In your opinion, does Professor Duy's argument apply to Australia? Explain your answer.