Recent movements in inflation expectations, as measured by the 5-year and 10-year breakeven inflation rates shown in the following chart, show a marked acceleration that has interesting implications for Fed policy in the coming months.

As the chart shows, beginning about January 21, both rates moved significantly above the FOMC’s 2% target rate; and the gap between the 5-year and 10-year breakeven inflation rates widened as well, with the 5-year rate now close to 2.3% and the 10-year rate at 2.2%. The increase in the 5-year rate in particular, and the timing of the acceleration (after Biden was inaugurated on January 20 and the Democrats took control of both the House and Senate) suggest that the market began pricing in the potential economic impacts of the president’s proposed $1.9 trillion pandemic stimulus package, together with the anticipated uptick in the availability of COVID vaccines.

However, there are reasons to believe that the recovery will be both uneven and perhaps slower than some might expect. The Fed staff forecast, revealed in the FOMC minutes released last Wednesday, showed a pickup in the second quarter, which has subsequently been buoyed by the sharp rise in consumer spending in January. But if that happens, then the policy formulation process will become much more challenging, since it is also the case that not all segments of the economy will rebound at the same rate. More importantly, while employment in some of the hardest-hit segments, such as hotels, travel, retail, and restaurants, are likely to bounce back, but perhaps only at first and not to former levels, it will not be clear to establishments whether the gains reflect simply a burst of pent-up demand or lasting recovery. Employers are likely to be extremely cautious, especially in low-wage market segments, and especially so if the stimulus legislation that ultimately passes contains the proposed increases in the minimum wage. Retail, for example, was under pressure from online buying even before the pandemic, and it is not clear that the online buying trend isn’t permanent. It is now being argued that millions of jobs have been wiped out by the pandemic and may never come back. (See Heather Long, “Millions of jobs probably aren’t coming back, even after the pandemic ends”, Washington Post, February 17, 2021). The author reports that significant structural changes are likely to have taken place with respect to business travel, working from home, and even the use of robots in activities as diverse as retail sales, human resources, consultants, etc.

If the Fed’s GDP growth forecast is realized, a slower jobs recovery relative to an acceleration in economic growth portends a potential policy conflict for the FOMC, especially with its recently announced “outcomes-based” policy objectives. For almost a decade, inflation has been below the FOMC’s 2% target, and hence the Committee could focus its significant policy accommodation to economic growth and jobs while paying lip service to trying to get inflation up a bit. Low inflation is not an important problem if the economy is growing and job growth leads to unemployment in the 3.5% range. But if the economy and inflation accelerate while employment lags, then the FOMC is faced with a significant goal conflict, especially if the Fed is focused on the employment situation in low- and moderate-income areas and among minorities. The FOMC’s January meeting minutes, released on February 17, reflect the Committee’s concerns about employment in these communities, and Chairman Powell emphasized them in his post-FOMC press conference, and the disparities were addressed subsequently in detail in the Fed’s February 19 Monetary Policy Report to Congress. Should employment gains lag in those important segments of the workforce, and indeed the recent increases in new claims for unemployment insurance for the first two weeks in February compared with January are a warning sign, then the Fed is faced with a policy dilemma. It can choose to tighten to fight inflation and risk an economic slowdown, or it can give up its inflation objectives in the short-run in favor of employment. The former puts the Fed at odds with the administration as well as with its full employment goal, while the latter means it will have to defer its inflation objectives. If it chooses the latter, then the FOMC can temporarily rationalize the delay, because of the lags incorporated into its now-average target for PCE inflation, and let inflation run. But in the end, the Committee may have to act to address inflation when it is already too late and risk causing an economic slowdown or even a recession.