Inflation Is Poised to Rear Its Head in 2021 But May Not Stick Around Long

• Inflation is expected to make a brief run at the Fed’s 2% target in early 2021.
• A resurgent economy that will benefit industries hurt by the Covid pandemic will help fuel the run.
• The move may not be sustained, however, due to labor market slack and some prices that will retreat.

As the economy picks up speed through 2021, investors could have to wrestle with some unexpected inflation pressures, if only for a little while.

Bond market traders and Wall Street experts have been signaling rising inflation from its current dormant levels.

In fact, many see inflation moving toward and perhaps a bit above the Federal Reserve's 2% target rate that has been elusive for much of the past decade. The primary driver is an economic reopening fueled by more Americans getting vaccinated, which will cause upward price pressure in industries that were held back during the coronavirus pandemic.

The trick, though, will be keeping it there.

The Fed considers some inflation good for the economy, as it signals growth and allows room for the central bank to act the next time a crisis comes along and demands help from monetary policy. However, a number of factors have conspired to keep inflation low, and they likely will help contain a rise in the coming months.

"We do expect interest rates to stay lower for longer and we expect inflation to remain contained," said Sunitha Thomas, national portfolio advisor at Northern Trust Wealth Management. "We do think that there are going to be some volatile prints on inflation coming up, and the market is going to react to that and try to decipher what that means. We think that's more cyclical than permanent."

At the Fed's meeting earlier this month, Chairman Jerome Powell acknowledged that the economy could see some price pressures, perhaps from rising energy.

However, policymakers would have to see a sustained level before taking any action, a stance now codified under the Fed's flexible average inflation targeting approach that it approved a few months ago.

"It's not going to be easy to have inflation move up. … It's going to take some time," Powell said during his post-meeting news conference. "What we're saying is we're going to keep policy highly accommodative until the expansion is well down the tracks. And we're not going to preemptively raise rates until we see inflation actually reaching 2% and being on track to exceed 2%. That's a very strong commitment, and we think that's the right place to be."

The question of rising inflation and the Fed's expected policy response is critical as the market enters the next phase of a strong recovery that began off the late-March pandemic-induced lows.

Investors increasingly are wondering whether the market is entering a bubble phase akin to the 2000 dot-com collapse, which was exacerbated by rising interest rates that were trying to keep pace with growth.

"As we scan the landscape of market commentary going into 2021, 'the return of inflation, perhaps with a vengeance' is a very, very common theme," Nick Colas, co-founder of DataTrek Research, said in a note this week.

Colas pointed out that 5- and 10-year break-even rates, or the difference between government bond yields and Treasury Inflation-Protected Securities, are both just a shade below 2%. That represents two-year highs and is a measure of where the market sees the consumer price index headed.

Such an environment, Colas pointed out, is not generally a good one for inflation-sensitive securities such as longer-dated bonds "unless one believes the market's enthusiasm for a 2021 global economic recovery is deeply misplaced."

Hopes for a sharp rebound

Goldman Sachs, for one, is at the head of the pack when it comes to hopes for the economy in the year ahead.

The firm's economic team sees full-year GDP growth of 5.9%, about 2 percentage points ahead of consensus estimates. Along with that growth projection comes the expectation that core inflation as measured by the Fed's preferred yardstick, the personal consumption expenditures deflator, will "briefly bounce above 2% next spring as we lap the weakest pandemic base effects," Goldman economists Alec Phillips and David Mericle said in a note.

"Several categories should bounce back from the direct and indirect disinflationary effects of the pandemic, including airfares, hotels, apparel, and financial services," they added. "But the pandemic has also had temporary inflationary effects in categories such as used cars and medical services, and the full impact of a weaker economy on shelter and other slack-sensitive core services categories has probably not yet materialized."

The Goldman team said only a "very tight labor market" would cause a sustainable inflation push that then would lead the Fed to raise rates, and that isn't likely soon.

Similarly, Citigroup economists expect inflation to push above 2% by April and stay there for several months, but then "settle back towards the 2% target by the end of the year." The firm sees rapid jumps in travel and apparel prices offset by softening used-auto and medical services costs.

Those expectations for a controlled inflation environment are helping fuel a mostly buoyant outlook on Wall Street for another year of strong returns.

"All of that has led us to having positive expectations around the reopening of the economy and more confidence about earnings expectations next year. We expect the Fed to stay very accommodative and for interest rates to stay lower for longer," said Thomas, the Northern Trust advisor. "We're looking forward to 2021."