The Fed's battle against inflation is far from over due to structural economic changes and high debt levels, according to BlackRock strategists.

“We think inflation will prove sticky and could surprise the Fed again as it did earlier in the year,” wrote strategists Wei Li, Catherine Kress, and Christian Olinger.

“Deficits are one reason we see inflation staying above pre-pandemic levels,” they said.

Since the pandemic, the federal deficit has grown at an alarming rate, reaching a staggering $1.9 trillion for fiscal year 2024. It's forecasted to reach $2.6 trillion by 2034, according to the Congressional Budget Office (CBO).

Meanwhile, the CBO expects the public debt to grow from 99% of GDP in 2024 to 116% by the end of 2034.

Economists have warned that large budget deficits will prevent inflation from declining in the future.

This is because deficit spending increases demand for goods and services, which can lead to higher prices as more dollars chase fewer goods.

It also distorts investors’ expectations about future inflation, which could erode the purchasing power of the dollar.

“Longer term, endless multi-trillion-dollar federal deficits will keep driving inflation higher,” warned Peter Schiff, and economist and founder of Euro Pacific Capital.

When combined with low interest rates, massive deficits “will create a lot more infltaion” in the long run, said Schiff.

Although the Fed seems convinced that it has turned a corner on inflation, not everyone at the central bank fully shares this view.

The inflation battle isn’t over

The Fed’s policy-setting board voted to lower interest rates by 0.5% last month—a move that Fed Governor Michelle Bowman said was a “premature declaration of victory” over inflation.

Bowman said policymakers should have lowered rates more gradually to “avoid unnecessarily stoking demand” and triggering another rise in cost pressures.

Similarly, BlackRock’s strategists said the jumbo-sized rate cut was a mistake because the Fed now “risks being surprised again if inflation proves sticky.”

Whether inflation is “sticky” is subject to interpretation. On the one hand, the Personal Consumption Expenditures (PCE) index—a key measure of inflation—fell to a 2.2% annual rate in August, the lowest in more than three years.

However, the Fed’s preferred core PCE index, which excludes food and energy costs, came in at a much higher 2.7%, which is well above the central bank’s target of 2%.

Although the Fed isn’t considering the federal deficit in its interest-rate calculus, the central bank’s governor has admitted that Washington’s spending spree isn’t sustainable.

The pace of deficit spending “is unsustainable,” Chairman Jerome Powell said in July. “In the long run, we’ll have to do something sooner or later, and sooner will be better than later.”

Moody’s isn’t convinced that Powell’s warning will amount to anything. The credit rating agency said Washington’s “fiscal deficits will remain very large, significantly weakening debt affordability.”

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