The Fed’s preferred inflation gauge, the core PCE price index, began the year well below the official inflation target of 2 per cent. But as Treasury yields have moved higher, so have the market’s expectations of higher inflation.
Overnight, Goldman Sachs said in a research note that as the epidemic improves, the U.S. economy will reopen in the coming months and scale inflation will rise.
Given that price pressures have risen in recent weeks, Goldman Sachs expects core PCE inflation in the US to peak at 2.4 per cent in April in the most basic case, much higher than during the lockdown in April last year, and to end the year at about 2 per cent.
But Goldman asked itself how high core inflation would go if it misjudged the direction of the economic recovery and mass vaccination led to a bigger surge in demand in sectors sensitive to the outbreak.
To this end, Goldman Sachs has run three scenarios looking at the impact on inflation of four key sectors where consumption and prices have fallen sharply during the epidemic: air transport, ground transport, and hotel and entertainment entry fees.
In the first scenario, Goldman Sachs assumes that US prices will have fully returned to their pre-crisis trend by the end of the year. To put that in perspective, that’s equivalent to a 29 percent year-on-year increase in airfares by the end of the year.
As a result, these four sectors will contribute 0.37% to year-end core PCE inflation, which means U.S. core PCE inflation will reach 2.17% in December 2021, higher than the base case forecast.
In the second scenario, Goldman Sachs assumes a sector recovery that deviates from its pre-epidemic trend and, other things being equal, the US core PCE inflation rate could reach 2.27 per cent by year-end.
The third scenario, mass vaccinations in the United States and pent-up demand earlier this year, leads to a surge in travel and entertainment spending later in the year.
If these four sectors are spending well above trend enough to recover the ground lost in 2020 within three years (2021-2023), they will contribute 0.56% to the year-end core PCE, bringing inflation to 2.36%.
As the year runs out, Goldman thinks the Fed will end the year with inflation suddenly well above its official target. What will the central bank do?
Goldman Sachs believes that by the end of the year, in the months when core PCE inflation is above 2 per cent, the unemployment rate will return to around 4.5 per cent, at which point the Fed could taper its asset purchases. That was a bit earlier than Goldman had expected.
But senior Fed officials have signaled that they are likely to choose to downplay the temporary impact of the post-outbreak surge in demand.
For example, Fed Chairman Jerome Powell said at a January news conference that if inflation picked up in coming months, it would be temporary. The Fed will be patient when it sees US inflation picking up.