Is inflation here to stay?

As we emerge from the crisis, ‘transitory’ inflation has become even stickier amid supply chain problems and sharply higher raw material costs. Indeed, US inflation printed at 6.2% recently – its highest level in 30 years, while the Bank of England (BoE) forecast inflation will peak at 4.4% next year.

Against this backdrop, M&G’s David Parsons, head of the public debt investment specialist team and Miles Tym, senior portfolio manager for government bonds, explored a key question in a recent podcast, namely: Have central banks lost control of policy?

“There’s no doubt that the current supply chain difficulties are exacerbating inflation problems – and the spot prints that we’re seeing in the UK and US probably overstate inflation dangers going forwards. Still, they are lofty numbers and a long way above target,” noted Tym. So, is investor concern rising that central banks are letting the inflation genie out of the bottle?

Inflation genie – uncorked

“It’s not so much where inflation is being priced in the next year or two because that’s high and potentially transitory,” noted Tym. “It’s more about where they are pricing inflation 10 years into the future, because that tells you what investors are thinking about [in terms of] more longer-term structural inflation.”

Geographical context also matters. For example, in Europe the 10-year inflation horizon is priced in line with the European Central Bank’s (ECB) target. Meanwhile, 10-year forward inflation in the US is priced at around 2.35%-2.4%, exceeding the 2% mandate that the Federal Reserve (Fed) has been operating along.

“I think the central banks would argue they’re not being overly accommodative.”

Across the pond, the UK is the scene of elevated pricing of inflation expectations with 10-year forward rates up at around 3.5%. 

“Clearly, the UK market is pricing in somewhat higher inflation over future decades than what we’ve had over 10-20 years and there’s some evidence that investors are becoming a bit concerned about inflation, albeit the current numbers do exaggerate any rise in inflation that you’re likely to see, because some of the factors are undoubtedly temporary,” said Tym. 

A transitory spike?

The BoE’s Monetary Policy Committee (MPC) recently elected to hold interest rates at 0.1% – a symptom of wider malaise or a move aligned with expectations for central banks to be overly accommodative in the face of rising inflation?

“I think the central banks would argue they’re not being overly accommodative,” said Tym. “They would probably claim that they’re being scientific than hoping inflation will come down, but nevertheless they are definitely assuming that almost all the inflationary spike we’re seeing will prove to be transitory and will fall out in the coming months or next year.”

The danger? If it turns out not to be correct, then central banks will be behind the curve unless they leap into action and squeeze inflation out over the next few months.

The views expressed in this document should not be taken as a recommendation, advice or forecast. The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance.