The COVID-19 relief package may pose a difficult dilemma for the Fed

Many observers are highlighting dire risks with President Biden’s $1.9 trillion COVID-19 relief package. Combined with a surge in private spending as the pandemic eases, it may push U.S. GDP well beyond the economy’s capacity. Overheated growth, in turn, may boost inflation above the Federal Reserve’s comfort level, requiring a sharper and earlier rise in interest rates than either the Fed or its watchers had been anticipating. Higher rates could trigger a collapse in the price of stocks, corporate bonds and other assets whose valuations had been stretched by years of ultra-low interest rates. The upshot of all this? The economy falls back into recession.

This scenario is hardly crazy, but each link in this contractionary daisy chain is uncertain, and it would take a perfect storm for all of them to materialize. Of these events, super-charged growth is undoubtedly the most likely. After the brisk rebound of the last two quarters, GDP probably is now only a few percent below its potential level.  So, considering that the Biden relief package amounts to about 9 percent of GDP, and that by some estimates households are holding on to another 7 percent of GDP in above-normal savings, it could easily be that as vaccinations proceed and life returns to normal, the unleashing of pent-up demand pushes the economy into boom territory. 

Such a boom may well trigger a transitory surge in inflation. Indeed, so-called base effects alone, which will occur when the falling prices of last spring drop out of the 12-month inflation calculation, will almost certainly push core (excluding food and energy) Consumer Price Index (CPI) inflation up from 1.3 percent in February to around 2 percent by May. Add in a hefty surge in aggregate demand, and perhaps lags in supply as many service-sector businesses take time to scale up after a year of diminished activity, and inflation rates north of 3 percent are quite possible later this year. 

But this bump in inflation is unlikely to be sustained. Over the next couple of years, demand will slow as fiscal stimulus wanes and the initial surge of post-pandemic spending is exhausted. Meanwhile, production will catch up as supply chains are restored and workers re-enter the labor force. And this will all play out against the background of an inflation rate that has persistently undershot the Fed’s 2 percent target for the past decade, reflecting some combination of worker reticence to push for wage gains, competitive pressures on markups and globalization, all of which have fed into subdued and well-anchored inflation expectations. These structural factors will not be thrown out the window merely by a few quarters of rapid growth.  

Because the Fed is already expecting a bump in inflation and will interpret it to be temporary, it is unlikely to tighten policy sharply in response. Indeed, under the new strategy it adopted last year, it will be looking for inflation above 2 percent for some time to offset the many years in which inflation was too low. To be sure, the stronger economic outlook engendered by the relief package and progress in vaccinations will likely lead the Fed to move up its intentions to tighten monetary policy. In the economic projections released by the Fed after its recent policy meeting, 2021 real GDP growth was revised up to 6.5 percent from 4.2 percent in December, and core inflation was revised up 0.4 percentage point to 2.2 percent.

Consequently, while most policymakers still expect that the Fed funds rate will not be raised until sometime after 2023, a couple more of them than in December see this first move happening next year or the year after. But even an earlier start to the tightening cycle will still mean historically low rates for a considerable time. And that should be manageable by financial markets, especially as the recovery in the economy strengthens corporate sales, profits and balance sheets.

So, while a sustained surge in inflation and inflation expectations that forces the Fed to sharply tighten policy is a dire risk, it is not a very likely one. The more likely risk is that the bond market over-reacts to the coming bump in inflation, pushing bond yields up much further.

Such a development would put a damper on the recovery and present the Fed with a difficult dilemma: Using asset purchases to push bond yields back down would help prevent a tightening of financial conditions, but at the cost of exacerbating already stretched asset valuations and possibly damaging the credibility of the Fed’s commitment to price stability. 

Conversely, the Fed could tighten monetary policy earlier than previously signaled in order to bolster its anti-inflation credentials, but this would put needless pressure on the economy if the rapid rise in prices was genuinely temporary. Faced with these unpalatable alternatives, the Fed’s best option is to do neither, but to stick with its plan – and explain it clearly – to gradually normalize policy once the economy recovers and inflation is set to moderately exceed its 2 percent target for some time. Given the diversity of views on the Fed’s policymaking committee, this muddle-through strategy seems a good bet.    

Steven Kamin is a resident scholar at the American Enterprise Institute (AEI), where he studies international macroeconomic and financial issues. Before joining AEI, Dr. Kamin was the director of the Division of International Finance at the Federal Reserve Board.