Government bonds sold off in February as investors digested a confluence of factors that look set to push inflation higher and could test central banks’ commitments to keep interest rates low for an extended period. In the near-term, rising commodity prices, higher shipping costs, and input shortages are set to push goods inflation higher. Meanwhile, accelerating vaccine rollout in most advanced economies is focusing attention on eventual re-opening in hard-hit services industries, where pent-up demand and a pile of savings could see demand recover faster than supply. That concern is particularly salient in the US where a $1.9 trillion stimulus package will add significantly to households’ purchasing power. US market-implied inflation (over the next five years) hit its highest level in a decade, nearing 2.5% in early-March.<\/p>\n
The response from policymakers will depend on whether the increase in inflation is viewed as transitory. At this stage we don’t think rising input costs and potential pockets of excess demand will result in a sustained upward shift in inflation rates in most economies\u2014with the usual caveat that inflation expectations must remain well-anchored. We expect central banks will look through higher and in some cases above-target inflation over the coming year. Investors appear to share that view\u2014an increasing spread between 5- and 2-year yields, for instance, suggests central banks are more likely to eventually raise interest rates but prospects of near-term hikes remain limited.<\/p>\n
Nonetheless, we think some central banks will hike rates sooner than markets are anticipating. Beyond a temporary, near-term jump in headline inflation, we expect a return to full capacity in the US and Canadian economies will help sustain near- or even above-target inflation in 2022. We see both the Fed and BoC raising rates modestly next year, earlier than their current guidance suggests. In other economies that have more slack to work through\u2014the UK, euro area and Australia\u2014interest rates will be held at current levels over our forecast horizon with QE programs continuing for the foreseeable future. We’ve already seen some of those central banks push back against rising bond yields with words (ECB) and actions (RBA). <\/p>\n