Inflation, deflation or reflation? Balance is essential as rate debate intensifies
Ritu Vohora of T. Rowe Price
Fuelled by abundant stimulus and optimism about the progress on vaccine distribution, markets have continued to push higher through 2021 – with the S&P 500 closing above 4,000 for the first time.
However, investors focus has shifted away from infection rates to rising inflation, rising bond yields and steeper curves.
Investors are concerned whether the market’s gains are sustainable, particularly given the rally in 10-year US Treasury yields this year, which has prompted bouts of market volatility.
By placing a greater discount on future earnings, higher yields have helped accelerate the rotation away from higher-valuation tech stocks and toward value stocks.
While some members of our investment team see the rising rates as an indicator of meaningfully higher longer-term inflation expectations, others view the move as simply a healthy reflection of the expected increase in growth as global economies recover.
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The intersection of unprecedented liquidity and a positive growth outlook – as well as the massive amount of pent-up demand set to be unleashed as economies reopen – has raised inflation expectations.
Furthermore, consumers in developed economies have accumulated excess savings of $2.9trn over the past year, the largest rise in household savings since World War II.
As household consumption comprises about two-thirds of GDP in advanced economies, even a partial release of these savings once lockdown restrictions are eased should result in a rebound in growth.
However, if demand outstrips existing supply, as we have already seen in semiconductors, shortages could lead to bottlenecks and price pressures.
So far, the Federal Reserve has reiterated its dovish stance, stating price pressures are likely to be mild and temporary. An uptick in core inflation will likely be viewed as a welcome sign of an improving growth outlook and warrant some tightening with a steeper yield curve.
Until unemployment levels make significant strides toward the Fed’s goals, accommodative policy looks here to stay.
Central banks are acutely aware of the underlying vulnerabilities rising policy rates would expose. Thus, we can expect them to tread extremely cautiously.
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The Fed has further indicated a higher tolerance of inflation and it is unlikely to act even if inflation rises temporarily to 3% to 3.5%. So, we will likely see an inflationary heatwave in the months ahead.
On the other side of the debate are long-term structural deflationary forces – such as ageing demographics, technology and globalisation – which will continue to keep a lid on inflation.
The reopening happens only once and there is still excess capacity to fill, while fiscal tailwinds will fade later in the year. Unlike the $1.9trn American Rescue Plan, which is front-loaded, the recently announced $2.25trn infrastructure package will be spread over a 10-year horizon.
This all points to a gradual rise in inflation, which should remain contained. The consensus view sees inflation peaking around the second quarter and then remaining weak.