Rising inflation and central banks’ reaction to it has turned into the key issue for markets in 2021.
After four decades of declining inflation across the advanced world, several cyclical and structural factors suggest that underlying price pressures will rise in the coming years.
In the near term, the easing of economically damaging virus restrictions over the course of spring and summer in the US and Europe should herald a rebound of economic activity that lifts inflation in both regions. The rise will be more pronounced in the US with its outsized fiscal stimulus.
Thereafter, a host of factors should underpin a trend towards sustained higher inflation through the remainder of the decade: an increasing shortage of labour as populations age, some further deglobalisation of goods trade and increased fiscal activism.
Whether the rise in inflation turns out to be a positive development or a negative one depends upon how much, or how little, it picks up.
If inflation rises towards pre-Lehman averages of around 2.5% in the US and UK and around 2% in the eurozone, that would be a positive development. A little inflation can help to grease the wheels of commerce.
In such a scenario, central banks could slowly scale back their stimulus without jeopardising the economic upswing.
However, a more pronounced rise in inflation beyond levels that central banks are inclined to tolerate would force them to step firmly on the brakes.
While some financial market participants worry that the advanced world could be heading towards the high inflation of the 1970s, such an outcome seems unlikely.
Despite their huge policy response to the pandemic, major central banks and governments are not likely to repeat the mistake of letting inflation get out of hand again.
If inflation really starts to rear its ugly head in a major way, independent central banks would react to it early in order to avoid a big monetary tightening that could jar the upswing and cause serious volatility in financial markets.
A benign scenario thus remains the most likely outcome.
At present, there is growing optimism in markets that the improvement in household balance sheets during the pandemic, as well as the faster diffusion of cutting-edge technologies by firms who have been forced to adjust to virus restrictions, can contribute to better economic performance in the years ahead.
Reacting to the outlook for higher inflation and real GDP growth, bond markets have moved a lot during the past year. Ten-year US Treasury yields hovered around 1.9% before the outbreak of the pandemic. They plummeted to around 0.6% in spring 2020 and remained below 0.75% through autumn. Since then, they have rebounded to 1.65%.
On the back of the surge in US yields, rates have also moved up in Europe. Yields have increased from a trough of approximately 0.2% to 0.75% for UK Gilts and from around 0.6% to -0.35% for German Bunds.
A further sustained rise in bond yields is likely to be a characteristic of the early post-COVID-19 upswing as inflation and productivity rise on-trend. Markets will need to adjust further.
This process may not always be smooth. Rising bond yields are associated with sharp losses for the holders of such paper as well as higher discounted cash flows for tradable companies – this may threaten some equity valuations.
At least for 2021, markets will continue to receive significant support from central banks. But, over time, the return to stronger growth momentum and higher inflation may limit the extent to which central banks may be inclined to step in when markets correct.
Kallum Pickering is senior economist at Berenberg Bank