More Stimulus Is Great, But Will It Fan Inflation?

Open sign in a small business shop after Covid-19 pandemic

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Prospects for another stimulus package might be driving economic growth forecasts higher, but some economists are warning to be careful what we wish for. Flooding the country with cash will likely push up consumer prices, and perhaps to levels that could have wide-reaching downsides, they say.

Key Takeaways

  • Another federal stimulus package would flood the country with cash again, potentially driving inflation up too much too quickly, some economists are warning.
  • While inflation is benign right now, if it accelerates too much, it could force the Federal Reserve to change course and even possibly increase benchmark interest rates sooner than expected.
  • Inflation fears have pushed up 10-year Treasury yields and weighed on benchmark stock indexes.
  • The Federal Reserve continues to offer reassurances, with Chairman Jerome Powell saying inflationary conditions "don't change on a dime."

The fear is that inflation could rise too quickly and by too much once people are able to spend freely again. They'll be armed with lofty savings, on top of additional government checks. And there's the pent-up desire to get out of the house and live again after almost a year of staying home.

Together, that could ignite buying activity more than the economy is ready for, particularly if the pandemic is still creating supply shortages, some economists and analysts say.

“It’s a perfect cocktail for inflation,” said Tom Essaye, a trader and founder of Sevens Report Research, a markets research firm.

A Chain of Events

A surge in demand, plus a weakening U.S. dollar and higher commodity prices, could indeed mean we’ll soon be paying measurably more at the register, but perhaps more important is the chain of events it would set off behind the scenes.

Last week, yields on benchmark 10-year Treasuries reached their highest level since the pandemic began, and that’s precisely what makes Essaye and others nervous. These yields rise in anticipation of higher inflation because inflation erodes the return on the bond payments.

Yes, stimulus checks and additional unemployment benefits are viewed by many as necessary to make sure the country can weather the next few months, but what will happen if the Federal Reserve starts to see some serious inflation risks?

Could that force the Fed to taper asset purchases that began as part of a concerted effort to restore jobs lost to the pandemic and get more normal levels of inflation? Or worse, would the Fed increase benchmark interest rates faster than it has said it would? (Right now, the forecast is to leave them at virtually zero until at least 2023 as the Fed temporarily targets an average inflation rate of “moderately above 2%” rather than its regular 2% target.) 

That could in turn dampen the heavily rate-sensitive housing and stock markets—two of the economic bright spots in the pandemic era. Mortgage rates have begun to rise from their historic lows in recent weeks. And just in the last few days, worries about the rising Treasury yields made a dent in benchmark stock indexes that not that long ago had been on a stimulus-inspired upswing.

“A significant rebound in inflation in the next year or two could potentially derail the recovery” if the Fed is “spooked” into raising rates sooner or higher than expected, Wells Fargo economists Jay Bryson and Sarah House wrote in a special commentary about “poking the inflation bear."

Reassurance From the Federal Reserve

For the Fed’s part, Chairman Jerome Powell has downplayed the risks, offering reassuring words about the “transient” nature of any upward pressure on inflation and promising to use its tools if inflation reaches an “uncomfortable” sustained level.

Inflationary conditions "don't change on a dime," Powell told members of the Senate Banking Committee in a hearing last week.  "We don't see how a burst of support or spending that doesn't last for many years would actually change those inflationary dynamics. If it does turn out unwanted inflation pressure arrives, we have the tools to deal with that." 

In January, the Consumer Price Index (CPI) was 1.4% higher than a year earlier, excluding energy and food prices that tend to be more volatile. This core inflation rate is well below the 2% to 2.5% range it stayed within for the years leading up to the pandemic.

Economists who are sounding alarm bells about what might fan inflation aren’t actually predicting huge leaps in this core rate, though they’re leaving room for things to change. 

Wells Fargo economists, for instance, forecast core inflation of 2.0% for this year and 2.5% for 2022, but say those could be underestimations. Some economists predict it will accelerate earlier in 2021 before retreating a bit. Many aren’t quantifying a worst-case scenario, pointing out supply shortages should ease.

“The second half of this year is going to be the question,” Essaye said. “The Fed is changing policy it has had for the last 20 years—letting inflation run hotter than it has in the last 20 years—and the federal government is unleashing stimulus like we haven’t seen since World War II, and there is no war.”

The Prospect of More Stimulus Checks

President Joe Biden's administration's $1.9 trillion stimulus proposal includes another round of stimulus checks—this time for up to $1,400 per taxpayer—and a higher federal supplement ($400) to weekly unemployment insurance benefits. 

Just a third round of stimulus checks alone could boost personal incomes by a combined $413 billion, lifting spending and adding to abnormally swollen savings accounts, according to BMO Capital Markets senior economist Sal Guatieri. Households have already boosted their savings $1.7 trillion over pre-pandemic levels—enough, if it was converted to spending, to cover three years worth of growth in spending at normal pre-pandemic growth rates, he said.

The expected surge in spending underpins forecasts for some pretty sizable economic growth. Economists at BMO, for instance, raised their gross domestic product (GDP) forecast to 6% from 5% this year, and at ING, to 6.5% from 5.2%, citing the expected passage of Biden’s stimulus package. Oxford Economics predicts the pending stimulus and a burst of spending will fuel growth “above 7%.” For perspective, annual GDP growth averaged 2.3% in the 10 years leading up to the pandemic.

Meanwhile, benchmark stock indexes including the S&P 500 and the Dow Jones Industrial Average soared to new record highs in February, and then retreated a bit as 10-year Treasury yields rose on inflation fears. The yield on the 10-year, which heavily influences borrowing rates for mortgages, auto loans and student debt, has jumped almost a full percentage point from its pandemic low, and at 1.42% on Tuesday, remains sharply higher than the 0.93% seen at the start of the year.

Other Contributing Factors

There are other factors beyond stimulus contributing to inflation fears. Higher commodities prices (think gold, oil, corn, and cattle) are making goods more expensive, as evidenced by a 13% increase in the Refinitiv/CoreCommodity CRB Index this year alone. Oil prices have also rebounded since last spring. And then there’s the weaker U.S. dollar, which makes imports—everything from Apple phones to BMWs—more expensive.

But the core question is what, if anything, will prompt the Federal Reserve to act. While moderate inflation is a natural byproduct of a growing economy, and the Fed says it sees any spikes from pent-up demand as transient, could that change?

Consider, for instance, a second measure of core inflation: the year-over-year change in the Personal Consumption Expenditures (PCE) index, excluding food and energy prices. This inched up to 1.5% in January from 1.4% in December, and according to BMO’s Guatieri, is higher than the core CPI rate of 1.4% for the first time in a decade. 

This will “catch the Fed’s attention, though it’s still a long way from moving above the 2% target,” Guatieri wrote in a commentary on Friday. 

Indeed, not everyone feels reassured by Powell, the Fed chairman, given the unprecedented times. Lawrence Summers, the former Treasury Secretary under President Bill Clinton, said Biden’s plans for a huge stimulus package risks causing an inflation outbreak.

“We have no experience with fiscal stimulus like that under consideration and the impact on inflation expectations,” he wrote in a Feb. 7 opinion piece for the Washington Post.

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  1. Wells Fargo. "The Economic Outlook: What Could Possibly Go Wrong? Part II: Poking the Inflation Bear."

  2. Rev. "Fed Chair Jerome Powell Testimony on Economic Recovery Transcript February 23."

  3. Washington Post. "Opinion: Larry Summers: My column on the stimulus sparked a lot of questions. Here are my answers."

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