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In our latest outlook, we have two inflation scenarios, distinguished mainly by what central banks decide to do about it. Too much market conversation centres on whether inflation is coming and not on what the policy reaction to it will be – the latter is far more important to investment outcomes. In our first inflation scenario, inflationary pressure starts to rise towards the end of this year, but crucially central banks decide to accommodate it, initially at least, by leaving monetary policy where it is. Specifically, the Fed waits until the trailing 2-year average of inflation reaches 3% before responding, which isn’t until late 2022. As a result, inflation starts to pick up next year and conventional bonds sell off further in the face of the inflation ‘surprise’. That could cause some short-term volatility in equity and credit markets, but ultimately this is a scenario in which real interest rates remain low or even fall – at least for a while. There is, however, an element of ‘policy error’ in this scenario, as central banks incorrectly interpret inflation running above 2% to be temporary and therefore maintain an accommodative policy stance.
SEE:Briefs: Fed keeps zero-rate outlook, sees inflation bump short-lived
Our second inflation scenario sees the Fed and other central banks react much sooner to a rise in inflationary pressure. Specifically, the Fed starts to taper and prepare the market for rate rise as soon as the trailing 2-year average reaches 2%, which is in late 2021. That is much sooner than the markets are currently pricing in.