How much stimulus is too much? Biden’s relief bill may have a nasty sting

Fresh figures this week revealed that US inflation remains relatively benign at 1.7 per cent but economists expect price rises to gain pace rapidly in the coming months. Forecasters predict inflation in the US could soar to as high as 5 per cent later this year but key for the Fed will be whether a spike is temporary or more sustained.

After promising to leave its federal funds rate at a record low range of 0 per cent to 0.25 per cent, persistent price pressures would leave the Fed in a Catch 22 situation.

“Monetary and fiscal policy are conducting a grand experiment with their aggressive measures. Risks of overheating are written in small print.”

Commerzbank economist Bernd Weidensteiner

Reining in a sustained surge in inflation would require the Fed to take action by raising interest rates as rate-setters tap the brakes to cool an overheating economy. That could prove painful for investors and tighten financial conditions sharply, weighing on a recovery and sending ripples through global markets. Blanchard believes this overheating risk could mean the stimulus becomes counterproductive for the economy.

“Can they seriously with a straight face say we’ve got growth of 6 per cent, inflation above 3 per cent and a reopened economy, we need to keep printing $US120 billion a month?” asks James Knightley, ING economist. “Inflation could remain elevated through next year, potentially triggering the Fed into earlier action on interest rates than they are currently signalling.”

The first signs of any movement could appear in the “dot-plot” chart released alongside next week’s Fed meeting.

These show the path Fed policymakers expect interest rates to take but economists expect them to remain subdued for now. The new flexible inflation target will give the rate-setters more breathing space to allow prices to overshoot before taking action.

Michael Pearce at Capital Economics says the Fed will use its statement to “push back on market expectations that rate hikes are rapidly coming into view. Officials appear to be setting the stage to look through any rebound in price pressures this year as transitory”.

Pressure could build on the rate-setters as the summer and reopening wears on, however. Pearce does not share the Fed’s confidence that “any upward move in inflation this year will prove temporary”, adding: “Wage growth is unusually elevated given the degree of spare capacity in the labour market and inflation expectations are trending higher.”

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One key ingredient for inflation is still missing. Powell has pointed to high levels of unemployment as a hurdle to tightening policy with large numbers out of work likely to keep wage pressures low.

However, Treasury Secretary Janet Yellen believes full employment may be reached as soon as next year. That would mean a much faster jobs recovery than the aftermath of the financial crisis.

Another jolt of stimulus could also be thrown into the mix. The latest package is aimed at just propping up incomes and businesses during the pandemic.

Biden promised to spend trillions of dollars more on his “Build Back Better” plan, including an infrastructure package that will spearhead his green agenda.

“Over the summer and into the second half of this year, I think we are going to have to see a change in stance from the Fed,” says Knightley.

The Daily Telegraph, London