Inflation is defined as the change in the prices of a basket of goods and services that are typically purchased by households and represents how much more expensive a set of goods and/or services has become over a certain period, most commonly a year. The most well-known measure of inflation is the Consumer Price Index (CPI), which measures the percentage change in the price of a basket of goods and services consumed by households.
Inflation leaves both positive and negative effects on the economy, depending on its level. In a high inflationary environment, the rapid increase in prices erodes the purchasing power of consumers and thus disincentives spending and investment. Deflation, meaning falling prices, is not desirable either. When prices are falling, consumers postpone non-essential purchases in anticipation of lower prices in the future. This means less economic activity, less income generated by producers and lower economic growth.
When inflation is low, stable and predictable, it is deemed good for the economy. Price stability helps consumers and investors make well-informed decisions on spending, saving, borrowing and investing. It is a very important ingredient for economic growth. Indeed, central banks’ primary objective is to keep prices stable so as to improve individual welfare.
In pursuit of price stability, most central banks aim to maintain inflation rates below, but close to, two per cent over the medium term. This signifies a commitment to avoid inflation that is persistently too high or persistently too low. To this end, central banks use interest rates and other measures to steer financial conditions so as to influence the overall level of activity in the economy and ensure that the inflation target is met.
Inflation leaves both positive and negative effects on the economy, depending on its level
The COVID-19 pandemic was an exogenous shock for the world economy which required a rapid response to a sudden plunge in supply and demand factors. Both central banks and governments intervened strongly and rapidly to keep the economy afloat. Indeed, both the European Central Bank (ECB) and the US Federal Reserve Board (FED) cut their main refinancing rates substantially to fight deflation and stimulate their respective economies.
Governments intervened heavily too, targeting those sectors and industries which were impacted the most. Central banks have bought huge amounts of bonds to combat deflation and boost credit, consumption and investments through their quantitative easing programmes. All these measures created the perfect environment for bond yields to plunge and prices to soar.
Indeed, the 10-year US treasury yield has gone down from two per cent, as at the end of 2019, to 0.5 per cent in April 2020, driving up prices by 11 per cent in just four months. European sovereign bonds followed suit, with the Italian paper registering the highest yield tightening in 2020.
The announcement of a successful vaccine by Pfizer and BioNTech and the subsequent approval for use by the US Food and Drug Administration (FDA) fuelled optimism among market participants. As more vaccines came to the market, confidence in the global economic recovery picked up. This optimism was further backed by key data like the Purchasing Managers Index and unemployment figures exceeding market expectations.
All this together with unprecedented massive monetary and fiscal response ignited a spectacular rally in global markets. Unsurprisingly, we have seen a persistent rise in inflation expectations from the March 2020 lows. This had caused jitters in some corners of the markets as analysts feared that this could lead to an alteration in monetary policies. Break-even rates, known as proxies, for inflation expectations have also ticked higher and exceeded the 2.2 per cent level.
The rise in inflationary expectations have pushed the US 10-year Treasury yield to 1.7 per cent, an increase of 75 basis points since the start of the year as investors are demanding better yields in the current upbeat environment. For such expectations to materialise, labour market conditions need to tighten sharply and push wage inflation higher.
Nevertheless, it seems that the perfect conditions for the fixed income markets is behind us and bond investors should be aware of the possibility of a further uptick in yields as economic conditions improve further.
The writer and the company have obtained the information contained in this document from sources they believe to be reliable but they have not independently verified the information contained herein and therefore its accuracy cannot be guaranteed.
Peter Paul Cilia, Portfolio manager, BOV Asset Management Ltd