*Regional manufacturing prices received are an average of prices received index from the Philadelphia Fed, Empire and Dallas Fed manufacturing purchasing manager indices. Data as of March 31, 2021 for regional manufacturing prices, February 28,2021 for small business prices. Sources: Macrobond, National Federation of Independent Business, Federal Reserve Banks of Philadelphia, New York, and Dallas.
Expect inflation to moderate after near-term spike, but risks remain to upside
We expect inflation readings in March, April, and May to spike on a year-over-year basis, but for technical rather than fundamental reasons, given very low readings in the comparison months during the pandemic last year. Beyond that, the combination of surging demand at a time of constrained supply is likely to contribute to near-term inflation as well, but these should dissipate over time as virus concerns ease, allowing production capacity to fully recover and as the economy adjusts to balance supply and demand. In the longer term, we expect inflation to settle back toward pre-pandemic levels given that we do not expect runaway inflation (as discussed in our “Inflation Dynamics” 2021 Capital Markets Forecast podcast).
However, we note that risks for inflation remain to the upside. As we note in “Stimulus and Inflation Jitters Lead to Stock Market Volatility,” and in our CMF and a podcast, longer-term inflation is dependent on the interaction between consumer and market expectations and the Fed’s new approach to policy. The upside pressures coming from supply disruptions are an important indicator to watch in the event that they start to feed into longer-term inflation expectations. In addition, the unprecedented magnitude and nature of fiscal stimulus (much of which sits directly in the hands of consumers), extraordinary monetary policy stimulus, and the Fed’s new average inflation targeting framework (which will allow inflation to run higher than 2% for some time, to make up for past undershoots of its target), also point to more upside risks to inflation relative to the previous cycle.
We remain overweight equities, as our base case is that the delicate dance between the Fed and inflation expectations will keep the economic recovery on its feet, assuming the Fed is able to keep inflation expectations in check and markets and consumers believe the Fed’s ability to do so within its new framework.
But we have rotated portfolios further into cyclical and value-oriented positions while paring back exposure to growth and low volatility factors to reflect our expectations for higher inflation and interest rates in 2021, as well as a steeping yield curve. We expect the Fed to remain on hold through 2022 despite our expectation for higher inflation, as its new policy framework allows it to tolerate a short-term overshoot of its 2% inflation target. This should keep the shorter end of the yield curve anchored, as longer-term interest rates adjust higher to reflect stronger growth and inflation expectations. See our March and April 2021 Capital Perspectives for more details on our portfolio strategies.
We are closely watching for risks in the event that markets and consumers start to expect short-term price pressures to persist. This could trigger a steady rise in longer-term inflation expectations, potentially forcing Fed rate hikes to come earlier.
 Committee for a Responsible Federal Budget, COVID Money Tracker, as of April 5, 2021.