Why financial markets need not worry about inflation, for now

Central banks will not withdraw monetary policy support until inflation rises above 2 per cent for a sustained period. While a modest increase in inflation is to be expected, it is unlikely to be enough to push interest rates higher for some years to come

Chris Iggo

Published: 3:30am, 11 Feb 2021

Why you can trust SCMP

On February 2, the Reserve Bank of Australia announced that it was maintaining its key interest rate target at 0.1 per cent and that it would extend its purchases of bonds by another A$100 billion (US$76.8 billion). It said it would not raise interest rates until inflation is comfortably between 2 and 3 per cent (it is currently less than 1 per cent). In no uncertain terms, the central bank argued that this is unlikely before 2024.

Australia faces an economic outlook common to many countries. Activity has been ravaged by the coronavirus pandemic, unemployment has risen, and spare capacity has emerged. However, the outlook is improving. Scientists have done an incredible job of delivering effective vaccines against Covid-19 that should bring down infection rates and reduce health risks.

That means a reopening of economies and a recovery in growth. China provides a road map in this respect. By the end of 2020, China’s fourth-quarter GDP growth rate had reached a level close to its medium-term target of 6 per cent per year. Current forecasts are for growth in the US and Europe to surge in the second half of 2020.

There is a lot of pent-up demand in the household and business sectors which should support spending once infection rates are lower.

Central banks aren’t going to be rushed into removing monetary policy support. Indeed, the message from the US Federal Reserve and the European Central Bank is like that from Australia – inflation needs to be consistently higher before interest rates are increased.

That is good news for borrowers, and it means governments can continue to pursue aggressive fiscal spending to support the recovery without financial markets getting concerned about the cost of borrowing.

Philip Lowe, governor of the Reserve Bank of Australia, attends a hearing before the House of Representatives economics committee in Canberra, Australia, on February 5, 2021. Lowe said interest rates will remain low for “quite a while yet”. Photo: Bloomberg

The key is inflation staying low. The Fed has said it wants to see inflation average above 2 per cent for a period before it raises interest rates. It could be waiting a long time. This century, the only periods that remotely got close to that were between 2000 and 2002 and 2004-2008, when core consumer price inflation was just above 2 per cent.

In Europe, inflation has trended lower since the European debt crisis. It shows little sign of picking up.

Some commentators worried that the period after the global financial crisis would see inflation rise as a result of quantitative easing. It didn’t. There is little reason to expect the post-Covid-19 crisis will be any different. Economies have seen the emergence of large output gaps and higher rates of unemployment. Inflation does not normally increase in such an environment.

Today, people point to monetary expansion and the size of fiscal programmes. Yet the initial impact of all this stimulus will be to get people back to work and allow businesses to reopen. It won’t lead to a rise in prices. If this is going to happen, it will only be when labour markets are tight and when businesses have so much demand for their products and services that they can increase prices.

There are other things that could affect inflation. Supply chains might have been disrupted by the pandemic, with potential shortages leading to some temporary price increases. If there are examples of this, the impact is likely to be short-lived as production and trade volumes rise again.

02:22

From fashion garments to protective gear: Bangladeshi factories turn Covid-19 gloom into boom

There could also be an impact on prices from policies that are put in place to accelerate the energy transition. Fossil fuel prices could be forced higher by taxes and regulation, and this could feed through to higher energy costs.

But again, this will be short-lived as the price of electricity derived from renewable energy is falling quickly. Over the longer term, we are unlikely to see the wild fluctuations in energy prices that characterised previous periods of dependence on oil.

Financial markets are experiencing a “reflation” trade. We should take this to mean that the risks of deflation are now much lower than a few years ago. Inflation may creep up as economic agents take on board the willingness of central banks to tolerate slightly higher rates.

The inflation-linked bond market in the US is pricing medium-term inflation at 2.4 per cent. That would be consistent with the Fed’s new inflation target and with continued recovery back to potential output.

This modest increase in inflation is to be expected and welcome. The odds are that it won’t be enough to push rates higher for some years to come. As such, we should look towards a long period of economic expansion.

Chris Iggo is the chief investment officer for core investments with AXA Investment Managers