February Producer Prices and Mid-March Consumer Sentiment

KEY DATA:  PPI: +0.5%; Goods: 1.4%; Services: 0.1%/ Sentiment: +6.2 points; Current Conditions: +5.3 points; Expectations: +6.8 points

IN A NUTSHELL: “With $2.8 trillion of government stimulus flooding the economy this year, growth is no longer the issue, inflation is.”WHAT IT MEANS:  The economy is coming back and the stimulus will insure that continues.  So, what is happening with inflation?  Well, it looks to be on the rise.  The Producer Price Index surged in February, led by a jump in energy and food costs. Excluding those categories, wholesale goods costs increased moderately.  But you cannot dismiss those increases, as the improving economy is likely to sustain the gains.  The index for finished consumer goods is rising sharply and that is one special category that needs to be watched carefully.  On the other hand, services costs are not going up very quickly at all.  As I have noted frequently, a rise in producer costs doesn’t necessarily lead to a rise in consumer prices.  But if the economy does pick up steam, firms may try to pass those costs along.

Households are really warming to the idea that they might be getting lots of money from the government.  The University of Michigan’s Consumer Sentiment Index jumped in the first half of March, with both current conditions and expectations up solidly.  The expectations index is somewhat depressed, but after the signing of the latest stimulus bill, and with checks possibly going out as soon as this weekend, look for that measure start to surge. 

IMPLICATIONS:President Biden signed the “Get us back to where we would have been without the pandemic” stimulus bill this week and massive growth is getting baked-in-the-cake.  Indeed, the latest Wall Street Journal and Blue Chip polls of economists (I am part of both) has the economy expanding between 5.75% and 6%.  If you put that into your spreadsheet and compare projected fourth quarter 2021 GDP with the level of GDP that would have occurred if the pandemic never happened and the economy grew at the same 2.2% rate it did in 2019, most of the negative economic effects of the virus could be largely wiped by year’s end.Of course, there is no such thing as a free stimulus package, especially when it contains so many free lunches for households, businesses and governments, so we need to switch our focus from worrying about recovery and start looking at what this massive growth rate might mean for inflation and interest rates. Yes, inflation is going up.  We see that in today’s producer price measure and we will likely start seeing it in the consumer price reports.  Given how fast the economy is likely to grow this year, demand should be strong enough to provide firms with a level of pricing power they haven’t seen in quite a few years.  And they will likely take advantage of that.  Expect inflation to exceed 2% by summer and keep going from there.  With rising inflation comes increases in mid- to long-term rates.  But the current levels are well below where they should be when the economy sheds the pandemic.  Since that will likely be in the next year, the markets should be starting to price in more normal (i.e., higher) inflation and rates should be moving back toward long-term trend levels.As for the Fed, higher inflation is likely to be received with open arms.  The change in the Fed’s guidance to average inflation of 2%, not 2%, means that given how long inflation has run below 2%, above 2% or even 3% inflation will be acceptable for an extended period.  In addition, the stimulus runs out by the last quarter of this year, and the economy will have to start standing on its own.  Growth could slow sharply in 2022 and the Fed doesn’t want to be caught raising rates into a moderating economy.  So, I still don’t expect any action from the Fed before the end of 2022, even if inflation runs hot this year.