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.
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—with 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—an 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.
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—the UK, euro area and Australia—interest 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).
- Higher oil prices will boost energy inflation in the near-term, while rising prices for other commodities combined with shipping delays and input shortages could contribute to firmer goods price inflation. Central banks tend to look through such transitory price increases and we expect they’ll do so again.
- We’ve upgraded Canada and US growth forecasts and still see upside risk to consumer spending if households draw down some of their cash holdings when the economy re-opens. Demand could outpace supply in such a scenario, which would also put upward pressure on inflation.
- Central banks have reacted differently to recent tightening in financial conditions. The Fed, BoC and BoE have tended to attribute rising yields to an improving economic outlook and confidence that central banks will achieve their inflation targets. The ECB and RBA have been less comfortable with higher term yields.
- In the US, fiscal stimulus will likely push the economy beyond full capacity in 2022. Despite its current commitment to low rates, we think the Fed will be first out of the gate with rate hikes. That should leave the US as the main driver of rising global bond yields going forward.
- We think the Canadian economy will also return to full capacity next year, which should result in the BoC raising rates in H2/22. In the near-term we look for the central bank to begin tapering asset purchases in April. Removal of accommodation—from shrinking QE to eventual rate hikes—will be a very gradual process.
Josh Nye is a senior economist at RBC. His focus is on macroeconomic outlook and monetary policy in Canada and the United States. His comments on economic data and policy developments provide valuable insights to clients and colleagues, and are often featured in the media.
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