Inflation Data Test Fed’s Strategy and Outlook

May 12, 2021

WASHINGTON—Federal Reserve officials have said increases in inflation this year will likely prove moderate and temporary, allowing them to hold interest rates near zero for years to come.

The recent surge in consumer prices, if it continues, could upend those plans.

If inflation remains persistently higher than they want, central bankers would have to abandon plans to keep their easy-money policies in place until the labor market is fully healed from the effects of the pandemic.

Some observers say the latest inflation figures show the Fed is already at risk of falling behind. So-called core prices, which exclude volatile components such as food and energy, rose 0.9% in April from March, the fastest one-month gain since 1981, the Labor Department said Wednesday.

Pershing Square Capital Management Chief Executive Bill Ackman , speaking at The Wall Street Journal’s Future of Everything Festival Wednesday, said the Fed should rethink its policy stance.


“I think they are going to have to raise rates, for sure,” Mr. Ackman said. “With rates where they are, there’s very good risk of the economy overheating.”

The Fed aims for inflation to average 2% over time. But economists and Fed officials expect prices to rise somewhat faster than that in the months ahead as trillions of dollars of fiscal stimulus course through the economy and newly vaccinated consumers strain the capacity of businesses to provide goods and services.

Fed Vice Chairman Richard Clarida said he was surprised by Wednesday’s numbers, but that they don’t change his view that higher inflation is likely to be temporary. He added that the Fed remains focused on restoring the economy to full employment and plans to keep its easy-money policies in place.

“Reopening is putting some upward pressure on the price level,” Mr. Clarida said. “Most of these increases in inflation will be transitory.” Other Fed officials speaking Wednesday echoed his view.

Some economists aren’t so sure. They point to sources of inflationary pressure that could last a while, such as widespread labor shortages.

Job openings reached a record at the end of March, while hiring unexpectedly slowed during the following weeks, according to figures released in recent days. That, some economists say, suggests that the labor market is hotter than implied by the 6.1% unemployment rate, meaning upward pressure on wages and prices could be more sustainable than Fed officials acknowledge.

‘With rates where they are, there’s very good risk of the economy overheating.‘

Some analysts say Wednesday’s data show the economy is suffering more from a lack of supply than of demand. If so, the Fed might be providing the wrong medicine.

In a typical downturn, the Fed lowers interest rates to boost demand by encouraging consumers and businesses to borrow and spend. But low rates don’t solve supply problems such as the microchip shortage that is holding up new-vehicle production, pushing up car prices. Nor do they prod people to apply for jobs if they are afraid of a coronavirus infection or have to care for children until schools fully reopen.

“We have dumped an enormous amount of resources into the economy that was designed for a Great Recession-style shock, and that’s not the shock we had,” said Tim Duy, chief U.S. economist at SGH Macro Advisors, referring to the weak demand that followed the 2007-09 recession.

Most Fed officials signaled in March that they expected to hold interest rates near zero through 2023. But many market participants increasingly say that they will need to move sooner. Ian Shepherdson, chief economist at Pantheon Macroeconomics, said the Fed is likely to begin raising rates in the second half of 2022.

Three decades of declining inflation prompted the Fed last year to overhaul its strategy for setting interest rates. Rather than raising them pre-emptively to prevent inflation from exceeding its 2% goal, as it had done for years, it will seek average inflation of 2% over time. The Fed currently wants inflation to moderately overshoot 2% for some time to make up for undershooting it for many years.

Fed officials say they expect to hold rates near zero until inflation reaches 2% and is headed higher, and the economy is at or beyond full employment. They have said since December they plan to continue buying assets at the current pace until “substantial further progress” has been made toward those objectives, a standard that Mr. Clarida said Wednesday “is likely to take some time” to achieve.

Some analysts say the new strategy, along with the Fed’s current guidance to provide plenty of lead time before reducing bond purchases, could constrain its ability to move quickly if necessary. That raises the possibility of either a sustained bout of higher inflation or a policy shift that is more abrupt—and damaging to the economy—than it would otherwise need to be.

Mr. Duy said “it is still an open question” whether the recent inflation flare-up will translate into sustained higher inflation.

Others say it has done so already. “It is clear that inflation is here,” Sen. Pat Toomey (R., Pa.), the top Republican on the Senate Banking Committee, said in a tweet after the inflation data were released. “The Federal Reserve can no longer pretend this is a distant problem. It is time for the Fed to revisit its accommodative policy stance.”

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