BlackRock Investment Institute

Macro insights

Investigating inflation

We believe investors are underestimating the potential for inflation expectations to rise, even in the near term. The surprisingly large rise in the U.S. July Consumer Price Index suggests a more rapid recovery in certain prices that have been hardest hit by the Covid-19 shock, such as airfares and hotels. Those prices remain well below pre Covid-19 levels, suggesting room for upside moves in coming months.

U.S. core PCE inflation in different scenarios, 2019-2020

Sources: BlackRock Investment Institute, U.S. BEA and Federal Reserve, with data from Haver Analytics. Notes: The chart shows U.S. core PCE inflation and the Fed’s projection in its June 2020 update. We show three scenarios based on different average monthly increases between August and December. We assume a 0.15% monthly PCE increase in July given the rise in the CPI that month..

U.S. inflation is picking up more quickly than Federal Reserve officials were expecting just two months ago. The Fed’s June projection for core PCE inflation was for inflation to stay subdued well below its target. But assuming inflation increases at moderate levels on average from August onwards, we could see core PCE inflation climb back to annual rates of 1.5% or higher – well above current levels. This comes as the Fed’s July meeting minutes show it is preparing to adopt an “outcome-based” forward guidance on policy. It would allow inflation to run above a 2% target to make up for past misses before considering lifting interest rates. We expect more details on this at the Kansas City Federal Reserve’s live-streamed economic symposium at Jackson Hole this week, where Fed Chairman Jerome Powell will be speaking on Thursday.

The medium-term inflation trajectory will depend on virus dynamics, the economic restart, and fiscal and monetary policy support. Together, a renewed uptick in virus infections, a slowing recovery and a looming fiscal cliff could also create some material downside risks. Covid-19 also causes material capacity constraints in a range of contact intense services. All in all, we see the Covid-19 shock as having widened the range of plausible inflation outcomes over the longer term, with the balance of risks tilting to the upside. The monetary-fiscal policy revolution, potential changes in central-bank inflation tolerance, debt overhangs, and deglobalization all point to a higher likelihood of a regime change in inflation dynamics in coming years.

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