The Likelihood of Inflation Overshooting and the Fed's Role

Some traders are betting that the Federal Reserve (Fed) may allow inflation to overshoot during the economic rebound. This raises the question: How likely is it, and why is the Fed considering such a move?

Chance of Inflation Overshooting

According to Jerome Powell, the Chair of the Federal Reserve, the FOMC intends to let inflation run hot until at least mid-2022 before raising interest rates. Based on current guidance, a rate hike might not occur until mid-2023 at the earliest. With the price of everything already on the rise, it's essential to hold onto stimulus checks as they may be needed in the future.

Two Main Inflation Measures

The Federal Reserve primarily focuses on achieving its core inflation target of 2%. Core inflation, which excludes volatile price items such as food and energy, is currently at 1.4-1.6. On the other hand, the Consumer Price Index (CPI) includes these volatile prices, such as food and energy, and can show a faster rate of growth. The Fed expects a rise in CPI driven by food and energy prices, but it will tolerate this rate increase until core inflation reaches 2-2.2, indicating a sustained growth in aggregate demand.

Explanation and Potential for Runaway Inflation

The Fed may not intend to allow runaway inflation, but the current massive increase in spending may still have inflationary consequences. Multiple factors can mitigate an inflationary spiral, but it's difficult to predict the outcome with certainty. The Fed has been trying for years to induce inflation, but it hasn't succeeded, possibly due to the misconception that inflation is solely a consequence of monetary policy.

Current Indicators and Real-World Evidence

Numerous indicators suggest that the Fed's approach may have some merit. Yields on U.S. Treasury bonds have rebounded to pre-COVID levels, and in fact, are lower than they were in January 2020 and all of 2019. If inflation were not a concern, why has there been a rebound in Treasury yields? The absence of actual, sustained inflation remains a contentious point. Therefore, until there is clear evidence of inflation, the current stance of the Fed cannot be fully confirmed or denied.

Conclusion

Inflation overshooting remains a possibility, especially given the massive increase in spending. While there are countervailing factors that could mitigate inflation, the current economic situation makes it difficult to predict with certainty. The Fed's strategy of allowing inflation to run hot until 2023 indicates a willingness to accept some level of inflation in the short term to achieve broader economic goals. As always, the real-world impact of these decisions will be closely monitored and analyzed.

Lastly, a chart of the yield on the 10-year Treasury bond is included for context. The scale here is symbolic: a yield of '15.00' represents the most recently traded price. If a picture is worth 1000 words, this single chart provides profound insights into the current economic climate.

Chart of the Yield on the 10-year Treasury Bond:

Note: The scale is 1. A yield of '15.00' means the yield on the most recently traded 10-year treasury was calculated based on the price paid for it to be 1.500.