Inflation: The price of recovery?

March 12, 2021 – Incoming economic data over the last month has been mixed. U.S. job growth in February was robust, with 379,000 jobs added, and the unemployment rate edged lower to 6.2 percent, according to the U.S. Department of Labor. Income growth and consumer spending were solid in January, the vaccine rollout gained momentum and Congress was on the cusp of enacting another round of fiscal stimulus. There are, however, a few headwinds to growth that emerged as well. Severe winter weather across the South and New England regions appears to have weighed on consumer spending in February, while supply chain issues have slowed the pace of inventory rebuilding. Strong domestic demand is boosting import growth but slower vaccine rollouts globally are weighing on export growth. Combined, these factors resulted in a downward revision to our Q1 real gross domestic product (GDP) growth estimate to 2.2 percent. While we downgraded a number of sectors, we now expect net exports and inventories to subtract as much as 2.2 percentage points from GDP growth this quarter.

Looking ahead to the rest of this year, Q2 will likely shape up to be the strongest quarter of the year (Real GDP chart) fueled by the passage of the $1.9 trillion stimulus package. The short-term boost from stimulus should begin to fade in the second half of the year as inflation pressures build. The likely result is that real, inflation-adjusted, economic activity will begin to decelerate as the purchasing power of consumers and businesses is eroded. The anticipation of higher inflation pressures later this year is driving interest rates higher and thus will likely reduce housing affordability later this year and into 2022.

Highlights:

• A downward revision to Q1 growth
• Inflation’s impact on consumer spending
• Interest rates climbing higher
• Risks to the outlook

^*Seasonally adjusted (SA), compound annualized growth rate (CAGR), year-over-year (YoY).

Sources: Visa Business and Economic Insights and U.S. Department of Commerce.

Inflation’s impact on consumer spending

Our outlook has reflected the expectation of higher inflation for some time, but recent data suggests price pressures are finally beginning to materialize. The February Institute for Supply Management survey data for both the manufacturing and service sectors rose dramatically, with the manufacturing sector’s prices paid component reaching its highest level since 2008. The reading was the first to suggest that pandemic-related global supply chain disruptions are beginning to lead to higher prices as constrained supplies globally in light of accelerating demand domestically lift prices.

We expect the headline Personal Consumption Expenditures deflator, the Fed’s preferred measure of inflation, to rise above 3 percent on a YoY basis and stay there until the first quarter of next year. The combination of supply constraints and another round of fiscal stimulus will be the key drivers. The higher inflation rates will ripple through the economy in two key ways. First, revenues will be higher for some industries as they are measured in nominal terms. Real spending however, is likely to be constrained as the inflation pressures erode some of the real purchasing power of consumers. The result is a gap between our outlook for real and nominal consumer spending this year (right graph on page 1 of Visa's U.S. economic forecast report).

Inflation, growth and interest rates

Beyond the inflation effects on the consumer sector, the expectation of higher inflation is also putting upward pressure on interest rates. The 10-year U.S. Treasury reached 1.60 percent last week, up from just 91 basis points at the start of this year. While the expectation of more federal debt issuance and stronger economic growth are helping to lift interest rates, the dominant factor in our view is the expectation that inflation will be allowed to exceed the Fed’s 2 percent target as the Fed awaits a more robust labor market recovery before beginning to hike interest rates or reduce its asset purchases.

Risks to the outlook

The risk to economic growth remains skewed to the upside in our view. The stimulus package along with a faster pace of vaccine rollouts could lift GDP growth higher than we currently expect. On the downside, we remain concerned about supply chain disruptions and the resulting inflation pressures, which have the potential to hold back real growth. We are currently assuming that the inflation pressures will be transitory, but should they persist, such rates of inflation would put downward pressure on real GDP growth and squeeze corporate profits.

Forward-Looking Statements

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