What does the Fed do now?

US consumer inflation data for April, released today by the Bureau of Labor Statistics, came as a nasty surprise, and markets have reacted badly.  Headline CPI rose 4.2 percent year-on-year, far above  market expectations for a 3.6 percent gain and marking the largest yearly increase since September 2008. There is a strong "base effect" at work here, thanks to the sharp fall in price pressures a year ago at the height of the first wave of COVID, but the data for April itself -- a 0.8 percent month-on-month gain -- also exceeded expectations.

The details of the report are not comforting. Core CPI rose 0.9 percent in the month, the biggest gain in almost four decades, bringing the year-on-year change in that index to 3.0 percent. Prices within sectors of the economy that are now reopening as the pandemic retreats -- lodging, air travel, recreation -- all contributed to the monthly increase. Somewhat oddly, the biggest single contributor to the gain was a 10 percent increase in used car prices, which now stand fully 21 percent higher than a year ago.

Fixed income markets have been fretting about a rise in inflation for some time now. Today's data reflect a combination of reviving consumer demand as the economy reopens and supply chains struggling to catch up. Little relief is in sight in the near term, not least with the closure of the Colonial Pipeline leading to higher average gasoline prices across the country, which will be reflected in the May CPI data.

The implications here are significant for both monetary and fiscal policy.  The Fed has made it clear that it will tolerate a spell of inflation above its long-term 2 percent goal in order to keep the post-COVID recovery on track.  Still, it must be surprised and concerned that CPI has moved above the target so far and so soon. It wishes to keep inflation expectations anchored at the 2 percent level for the longer term, so it will have to assess how long consumers and investors will tolerate data like today's without starting to anticipate persistent price pressures. No change in either policy or rhetoric is likely any time soon, but the timetable for eventual tightening has undoubtedly shortened. 

As for fiscal policy, the strong GDP growth data for Q1 and today's evidence of rising price pressures will undoubtedly embolden the voices in Washington speaking out against President Biden's planned stimulus measures. Reports of record-high job vacancies across the economy indicate that it will be difficult for supply chains to react quickly to rising demand. That implies further supply-side price pressures and only adds credence to the Republican argument that generous benefit programs are deterring people from returning to the workforce. Even though that argument is largely without merit, the case for massive fiscal stimulus is becoming steadily harder to see.