However, price data could surprise on the upside, especially in the US.
Getting exposed to inflation breakevens would help reduce the risk of taking a hit when yields grind higher.
Although deflation fears appear to have been vanquished, inflation has remained surprisingly low. However, upward pressure is building gradually and price data may eventually surprise to the upside, especially in the US.
Going global. Inflation is often considered a domestic phenomenon. However, the past decades have seen the growing influence of global factors (e.g. rising world trade, lower transport costs, market deregulation, offshoring, digitalization). With market competition going global, producers are always fighting to lower operating costs, helping keep a cap on goods prices. On the other hand, services prices – which are mostly produced and consumed domestically – have continued to creep up.
Wage pressure still missing. The fall in unemployment has failed to trigger as much wage pressure as in past economic upturns. In the US, the unemployment rate stands below its long-term equilibrium (measured by the non-accelerating rate of unemployment or NAIRU). This would normally lead to a faster rise in wages but there have been few signs of a pick-up. Academic surveys suggest that central banks’ success in tackling inflation has led to more flexible labour markets.
Get ready for inflation surprises. Inflation surprises have been infrequent despite stronger growth and high commodity prices. Oil has become a less powerful inflation driver in developed market economies thanks to efficiency gains and the emergence of substitutes. On the bond market, breakeven inflation rates (the yield gap between nominal and inflation-linked bonds) have remained well anchored, signalling limited inflation concern. Even the Fed does not seem particularly worried about inflation, expecting only a gradual rise in prices.
However, several factors should now push inflation higher, leading to upside surprises. The tax boost could lead to economic overheating and wage pressure as the labour market becomes even tighter. In addition, we expect dollar weakness to drive import prices up.
We recommend favouring short duration on bond markets. Investing in inflation breakevens would help reduce the risk of taking a hit when yields grind higher. We expect inflation to be higher than current expectations in 5 and 10 years.