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Economic Research: U.S. Markets See Inflationary Ghosts; Macroeconomic Signs Disagree


As the U.S. economy looks set for its best year of growth since Beverly Hills Cop and the original Ghostbusters were battling for box-office dominance (that was 1984, for you young'uns), some financial market commentators are suddenly convinced that spiraling inflation is on the horizon--and that the Federal Reserve will be forced to tighten monetary policy sooner than it would like.

We disagree.

Yes, the massive government support measures to combat the effects of the pandemic--notably the trillions of dollars in fiscal stimulus from Washington and the Fed's easing of credit conditions--make it more likely that prices will rise. The increase in the yield on benchmark 10-year Treasury notes reflects this view, and 10-year inflation expectations have moved in parallel.

While S&P Global Economics agrees that inflation is likely to pick up in the near-term--with the Consumer Price Index (CPI) likely to surpass 3% in April--we believe it will be transitory, tied primarily to the "base effect" from pandemic-depressed prices last year and the reopening of economic activity as coronavirus vaccine rollouts continue. Even beyond the spike in April and May driven by base effects, we think higher levels of stimulus-encouraged household savings will increase demand for goods and especially services, spurring inflation above 2% over the span of this year--but hardly to "runaway" levels.

Supporting our macroeconomic-based view, S&P Global Ratings' survey of analysts covering nonfinancial corporate entities suggests that many U.S. sectors will likely face increasing input prices this year. We expect industries will largely be able to manage rising prices through cost-saving strategies, productivity gains, or by passing them through to customers. We also don't expect this pressure to persist beyond 2022, as the economic recovery takes hold and business activities return to more normal levels.

Investors have also priced in higher inflation farther out (see chart 1). The central estimate of market-based CPI inflation expectations for the next five years, derived from options-based pricing, has moved up to 2.52%--back to 2013 levels, and over three times inflation expectations of 0.8% in the beginning of last May (see chart 2) as the pandemic recession wound down. A near-term rate of 2.2% CPI inflation would be consistent with the policy-setting Federal Open Market Committee's (FOMC) personal consumption expenditures (PCE) inflation target.

Against this backdrop, the yield on 10-year Treasuries (used as a benchmark for rates, such as those on mortgages) recently climbed above 1.7% and fed funds futures are pricing in a rate hike in fourth-quarter 2022. S&P Global Economics believes the Fed won't raise rates until third-quarter 2023 (see "Economic Outlook U.S. Q2 2021: Let The Good Times Roll," March 24, 2021). Even with the recent rise, the 10-year yield is still historically low--merely 20 basis points above the all-time low before the pandemic and still negative in real terms.

Chart 1


Chart 2


Full Of Sound And Fury, Signifying Nothing

We don't see runaway inflation as an imminent risk--actual inflation is nowhere near what markets are pricing in, and even with a near-term price lift, it won't be enough to signal runaway inflation. In fact, it barely eked higher in February, as rising gasoline prices lifted overall CPI just 0.4%, and core CPI--excluding food and energy--rose just 0.1%. On an annual basis, core CPI rose 1.3% and core PCE rose 1.4%--well below the Fed's 2% target.

Inflation would have to persist above 2%--perhaps for several quarters--to spur policymakers to move. It's more likely that any near-term jump will abate later this year as long-term macroeconomic factors--such as globalization and the "gig" economy--keep prices in check while the economy recovers.

Although fiscal stimulus will help fill the demand hole as the economy heals, we don't expect the U.S. labor market to fully recover until midway through 2023. Moreover, inequality and long-term demographic pressures may also continue to weigh on prices over the coming years. This is particularly true when considering health care inflation's impact on overall inflation. Health care services spending, which constitutes roughly 17% of PCE (the third-largest component after housing and utilities) has become increasingly important over the past several decades, and will continue to have an outsize impact on core PCE inflation (see "Economic Research: What's Next On The Path For U.S. Inflation And Monetary Policy", July 31, 2019). The American Recue Plan, passed last month, broadened the Affordable Care Act in ways that brings health insurance to more folks at lower cost, capping healthcare inflation.

It's All About That Base Effect

The normalization of interest rates is a natural--and desired--part of the economic recovery. It implies that moderate demand and wage increases are reemerging after a lost decade and that the interest rate structure could return to more normal levels (see "Economic Research: Orderly Global Reflation Will Support The Recovery From COVID-19," March 22, 2021). And while unsteady jumps in rates could lead lenders and investors to reset their risk-return demands--pushing up the cost to borrow--the inevitable market adjustments on a strengthening economy will lead to better outcomes overall.

For now, a strong base is more responsible for higher year-over-year inflation than what we normally see in the economy--particularly in energy prices, which plummeted 9.5% month-over-month in April as the pandemic emerged in the U.S., its sharpest monthly decline since 2008. Given that more than 90% of American households were under some form of social restriction, mobility plunged. In April 2020, headline PCE rose just 0.5% year over year, its slowest pace since December 2015. Core PCE, excluding food and fuel, (the Fed's preferred measure) rose a scant 0.93%, the least since December 2010.

Same As It Ever Was

While much ink has been spilled over fears of a surge, there is no getting around the fact that in the nine years since the FOMC announced its 2% inflation target, 12-month core PCE inflation has averaged only 1.4%--the same level as its February reading, with price levels only slowly making up lost ground (see chart 3). Since the mid-1990s, both headline PCE and core PCE prices have increased at an average annual rate of just 1.8%. Core PCE prices slipped further, to 1.53%, from 2010 to 2020 (see chart 4). It's especially striking that core inflation in the U.S. has remained within a two-percentage-point band of 0.9%-2.9% in the past quarter-century or so, considering the political and economic events during that time.

Chart 3


Chart 4


After the transitory factors, such as the base effect and reopening spending spree, we expect the long-term trends that have held prices down for decades to resurface. One of these is globalization. With advances in technology, things can be made anywhere around the world, making it difficult to raise wages or prices. If a business does raise wage costs or prices, buyers can find a cheaper place in the world to purchase a product or (nowadays) service. In addition, the "gig" economy often means less bargaining power for workers, resulting in lower wages. These are all reasons explaining why price inflation has been less responsive to domestic labor market slack--the so-called flattening of the Phillips curve (see chart 5).

Policymakers at the Fed--who have long relied on the Phillips curve to guide monetary policy--even acknowledged its flattening by explicitly tweaking their monetary policy framework last August, so that it now puts more emphasis on shortfalls in employment and less on the fear that low unemployment could spark higher inflation. With its policy shift, the Fed now also promises to aim for 2% inflation on average over a period of time, rather than using 2% as a hard annual target, as it had since 2012.

Chart 5


Chart 6


Beta testing several factors on inflation highlights how inflation expectations now dominate price changes in the future (see chart 6). We found that long-term inflation expectations, shown by the slope of the price index trend line around which actual price fluctuates with business cycles, have the largest impact on future prices, while economic slack (measured by unemployment gap, short-term inflation expectations, and relative import prices) seems to have less impact on future inflation trends. In this regard, once people start to believe that prices are pretty stable, that belief tends to preserve itself--so much so that consumers are likely to dismiss near-term distortions in inflation as transitory. And with inflation expectations well-anchored at historically low levels at both the household and firm level, the economy essentially has a longer runway to keep adding jobs before inflation rises and the Fed has to tighten policy.

No Runaway Inflation For The Fed To Fight

Our analysis uses a simple reduced-form specification of headline inflation, based off of a model then-Fed Chairwoman Janet Yellen presented in 2015. (see "New Kid In Town" section and Appendix). This employs an identity of headline inflation, and a variant of an "inflation expectations-augmented" (hybrid) Phillips curve that includes a global input price shock variable.

According to our baseline hybrid model estimation, after being stuck at around 1.8% over the last six years and to 1.7% in 2020, professional forecasters' long-term inflation expectations move up to 1.9% by year-end 2021, and reach 2% by 2024. In this baseline scenario, second-quarter 2021 core PCE would be as high as 2.5% (0.7 percentage points higher than the average core PCE since the early 1990s) because of the macroeconomic drivers recovering and, more importantly, the base effect (see chart 7). The higher than normal year-over-year inflation this year brings PCE price levels back to the pre-pandemic trend from last year's sharp decline.

Chart 7


Once back to the trend level, the sensitivity estimates from our hybrid Phillips curve model suggests core PCE inflation will move down from 2.5% in second-quarter 2021 to 2.0% by the end of 2021 in our baseline estimation.

In 2022-2024, core inflation would gradually increase to 2.3% by the end of 2024 in our baseline scenario, as long-term inflation expectations reach 2% and the unemployment rate dips further below 4%. Compared with historical values (see chart 4), our forecasted inflation numbers from 2021 to 2024 overall would hardly be considered runaway inflation comparable to the late 1960s and 1970s, or even the moderately high inflation averaging 2.5%-3% seen in 2004-2008.

To be sure, the path of long-term inflation expectations is uncertain at this point of time. Using the parameter estimates from the above model, we conduct three sensitivity analyses around how inflation could evolve over 2021-2024 based on different paths for long-term inflation expectations assuming no Fed intervention. Our aim in this exercise is to simply provide some likely guideposts for the pace of inflation in three different scenarios of long-term inflation expectations--also recognizing the challenge in understanding how inflation expectations are formed.

Chart 8


Chart 9


  • First, our baseline scenario, discussed above, assumes inflation expectations could move up to 2% by fourth-quarter 2024. As a result, the path of core PCE warms to 2.2% by first-quarter 2024 and 2.3% by year-end. The Fed would have reason to raise rates sometime in 2024, in line with its March projections. This assumes a high level of credibility for the central bank's new policy framework.
  • Alternatively, the Fed may operate under imperfect credibility. Despite an ultra-easy policy environment, long-term inflation expectations may remain unmoved at 1.8% (2010-2020 average) at year-end 2024. Core PCE reaches just 2.1% by year-end 2024, not high enough to meet the Fed's new criteria for raising rates.
  • Finally, long-term inflation expectations may overshoot to 3.0% by the end of 2024, a rate last held between 1992 and 1995. In this scenario, core PCE inflation moves up to 2.3% by third-quarter 2022, and with no Fed intervention, hits 2.9% by year-end 2024. The Fed's maximum employment mandate may keep it on the sidelines at least until late 2022 in this scenario.

We then considered the impact of the three scenarios, framed against the backdrop of price levels: if inflation had stayed on its 2% year-over-year inflation path starting in 2018 (the purple dotted line) or, if inflation remained anchored at its 10-year average of just 1.8% year-over-year (the pink dotted line). All three scenarios saw a huge transitory bounce in PCE prices in the second quarter from the base effect (see chart 8). Through second-quarter 2022, all three scenarios remained below what the core PCE price level would have been if the economy stayed on a 2% year-over-year inflation path since 2018 (see chart 9). The 3% inflation expectations scenario crosses the 2% y/y path in third-quarter 2023. The moderate expectations scenario would cross the 2% path in third-quarter 2024, and the "remains low" scenario never crosses the 2% path.

There's A New Kid In Town

In line with the larger role of well-anchored long-term inflation expectations, then-Fed Chairwoman Janet Yellen presented a model in her 2015 speech "Inflation Dynamics and Monetary Policy."

We use a similar simple reduced-form specification of headline inflation that employs an identity of headline inflation, and a variant of an "inflation expectations-augmented" hybrid Phillips curve that includes a global input price shock variable. This model formally estimates how each component of the expectations-augmented Phillips curve--near term expectations (of households), long term expectations (of professional forecasters), persistence (of one-period-past inflation), slack (the unemployment gap), and global input shocks (reflected in relative input prices of non-petroleum imports)--contributes to core inflation.

Our model assumes the unemployment rate will decline further (as in our latest forecast) to 5.0% by year-end, reaching its precrisis rate by 2023, and we assume households' one-year inflation expectations will rise to 2.8% by year-end, climbing slowly to 3% by 2024. We forecast non-petroleum import price inflation to become positive beyond the third quarter. We adjust the professional forecasters' 10-year long-term inflation expectations estimate in each scenario. This simple two-equation model (see Appendix) fits relatively well with actual headline inflation (see charts 10 and 11).

Chart 10


Chart 11


For Corporates, Input-Price Pressures Tend To Be Temporary

Complementing the macroeconomic view, S&P Global Ratings' survey of ratings analysts indicates that many U.S. corporate sectors are facing input price pressures this year, which are largely manageable through cost-saving measures, gains in productivity, or by passing them through to customers (see chart 12).

The forces behind the increase in input prices are varied, with the pandemic and associated recession among the most cited. For sectors such as media and entertainment, health care services, and retail and restaurants, there are costs of complying with COVID-19 protocols onsite--including sanitation and providing personal protective equipment. For others, supply-chain disruptions because of pandemic-induced production constraints and the sudden demand uptick will increase input prices. For example, semiconductor shortages mean the auto industry could suffer a net loss of production of up to 3 million units this year (roughly 3%-5% of global production), testing automakers' willingness to pay higher prices for chips (see "Global Semiconductor Shortages Could Chip Away At The Auto Sector's Recovery In 2021", published Feb. 10, 2021). Sectors such as consumer products are also seeing a surge in shipping costs.

Chart 12


Relatedly, rising commodities prices are driving up costs, especially for manufacturing sectors. For instance, prices for steel and copper have hit decade highs only a year after dropping to near-decade lows. We raised our assumptions for most metals prices for 2021-2023 as demand is rebounding while supplies remain stubbornly tight. Declining ore grades, producer discipline, and trade barriers are all contributing to a price spike so far this year, but we expect prices will moderate because of the tendency for shortages to be rectified through incremental production and substitution. At least some of this pressure from higher commodities prices then flows downstream to industries such as autos, capital goods, and building materials. Transportation segments including airlines and railroads are also affected by higher oil and diesel prices.

Trade policies and tariffs have stepped away from the spotlight recently but continue to be a key cost factor for industries exposed to cross-border supply chains (China, in particular). These include technology, chemicals, capital goods, and agricultural commodities. Long-standing frictions between the U.S. and Canada over softwood lumber influence prices, weighing on the building materials sector.

Services sectors, on the other hand, are more concerned with labor costs. For media and entertainment, the price of talent keeps rising. The health care-services sector has been short of skilled nurses to meet the staffing needs. As the lodging industry starts to rebound from its deep dip, it will likely grapple with higher property and room taxes as cities try to fill budget holes. Companies in the sector may also have to raise wages to attract labor, since many hospitality workers have left the industry since the pandemic began. Furthermore, a potential boost in the federal minimum wage to $15 an hour could be a risk for retail, restaurants, and gaming operators, especially smaller ones.

Finally, ongoing secular changes influence input-price dynamics as well. For example, retailers are increasing investment in e-commerce infrastructure. Media and entertainment companies are competing for original content as streaming services proliferate. Higher costs associated with environmental, social, and governance factors are also a concern for companies, such as those in the metals and mining industry.

Cost-Cutting, Capacity Utilization, And Pass-Throughs

Some sectors are dealing with input-price pressures by actively implementing cost-saving strategies or boosting productivity. For example, health care-services providers are switching to volume-based payment models to account for higher labor costs. Homebuilders are adopting technology that can lower overhead with more efficient selling and closing processes. Consumer-products companies are focusing on cost-reduction programs and a more favorable product mix.

Also, capacity utilization may still be below pre-pandemic levels this year for certain sectors; therefore, total costs are manageable even if unit input prices go up. In the hard-hit cruise sector, for example, ships are in various stages of lay-up, which means they are minimally staffed and use very little fuel. When cruises resume, passenger capacity will be lower initially, so cruise operators will hire fewer employees. We also expect the industry will use less fuel since the focus will at first be on shorter trips, and operators have scrapped older, less efficient ships.

Another channel alleviating higher input prices is the pass-through to customers. We see significant variation across and within sectors in terms of ability to pass higher prices along to consumers (see chart 12). In general, companies operating in highly competitive and fragmented markets (e.g., building materials, specialty apparel), facing pricing scrutiny (e.g., health care services), or still suffering from weak demand (e.g., airlines, oil field services) may find it more difficult to pass on higher input prices in the near term. Conversely, homebuilders, supported by strong demand and historically-low interest rates, have been able to pass through higher costs and expect to continue doing so. Agricultural commodities and data centers also rely on pass-through pricing mechanisms.

All told, we expect the input price pressures will be largely manageable this year from businesses' perspective. While this does mean consumers could see prices increase, this is likely to be transitory. Looking ahead to the next two to three years, most U.S. corporate sectors expect the current pressure to moderate, as pandemic-related disruptions lessen, the economic recovery unfolds, and productivity and efficiency continue to improve.


(1) Core inflation (t) = 0.22 core inflation (t-1) + 0.63 long-term inflation expectation (t) + 0.17 short-term inflation expectations (t) – 0.06 slack (t) + 0.35 RPIM (t) + constant

(2) Inflation (t) = core inflation (t) + weighted RPIE (t) + weighted RPIF (t)

The model combines a simple reduced-form forecasting equation for core PCE inflation (equation 1) and an identity for the change in the price index for total PCE (equation 2) as a function of time (t), where inflation and core inflation denote year-over-year percent change of the respective price indices, RPIE and RPIF are annual growth rates for prices of energy and food components, respectively, both expressed relative to core PCE prices and weighted by their share in total consumption (4% and 8%, respectively). Coefficients in the equations are derived from regression over 1992-2019.

In the core inflation equation, short-term inflation expectation is represented by the University of Michigan's one-year forward expectations by households. Households may not be able to correctly identify the current level of inflation, but they have a fairly good understanding of changes in the trend of current inflation and these changes are likely to inform their expectations about future inflation. Long-term inflation expectation is represented by the 10-year inflation forecast from the Professional Forecasters' Survey. Slack denotes slack in the labor market, calculated as the unemployment rate less long-run natural rate of unemployment, and RPIM controls for the effects of changes in the relative price of core imported goods, defined as the annualized growth rate of the price index of non-energy imported goods less the annual core PCE inflation, all multiplied by the share of nominal core imported goods in nominal GDP.

Broadly in line with the literature, growth of non-oil import prices is taken as a function of its current and lagged values, the trade-weighted nominal effective exchange rate, and the foreign trade-weighted producer price index, where we construct trade-weighted global PPI by combining top U.S. trading partners--Canada, Mexico, China, Japan, the eurozone, and the U.K.

Finally, even though the Fed switched to the new flexible average inflation targeting framework and welcomes slightly above 2% inflation for some (unspecified) time, we assume long-term inflation expectations are not likely to instantaneously move up, if at all. As former Fed Chairman Ben Bernanke and Federal Reserve Board economist Michael T. Kiley (2019) point out, "the assumption of full credibility of the (monetary) policy framework is probably too strong, especially during a period of transition to a new regime".

The views expressed here are the independent opinions of S&P Global Ratings' economics group, which is separate from but provides forecasts and other input to S&P Global Ratings' analysts. S&P Global Ratings' analysts use these views in determining and assigning credit ratings in ratings committees, which exercise analytical judgment in accordance with S&P Global Ratings' publicly available methodologies.

This report does not constitute a rating action.

U.S. Chief Economist:Beth Ann Bovino, New York + 1 (212) 438 1652;
U.S. Senior Economist:Satyam Panday, New York + 1 (212) 438 6009;
North America Credit Research:Yucheng Zheng, New York + 1 (212) 438 4436;
Contributor:Shuyang Wu, Beijing
Research Contributor:Arun Sudi, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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