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Policy Insights

Should Investors Continue to Ignore Inflation?

How the path of inflation will impact fixed income markets.

Arif Husain, CFA, Head of International Fixed Income
Andrew Keirle, Portfolio Manager
Kenneth A. Orchard, Portfolio Manager
Quentin S. Fitzsimmons, Portfolio Manager
Ju Yen Tan, Senior Portfolio Manager in the Fixed Income Division
Saurabh Sud, CFA, Portfolio Manager

Key Insights

  • With central banks close to exhausting all their options, it’s time for governments to step up fiscal policy to revive economies and support inflation.
  • A material boost in government spending could be conducive for the reflation trade in the coming quarters.
  • In the short term, inflation risk is likely to remain low.

Global growth is approaching an inflection point; either the slowdown becomes entrenched and leads to a recession, or the cycle gets extended as interest rate cuts and fiscal stimulus start to take effect. What does this mean for the inflation outlook? This was a key discussion point during our latest policy meetings with the investment team debating the risk that price pressures may start to rise.

(Fig. 1) Inflation Expectations Continue to Fall Despite Central Banks Easing
U.S. and eurozone 5‑year, 5‑year forward inflation swap rates
As of September 30, 2019

Sources: Bloomberg Finance L.P. Used with permission of Bloomberg Finance L.P. Analysis by T. Rowe Price.

For more than a decade, developed countries have been stuck in a low‑inflation environment despite the best efforts of central banks to engineer pressure on prices. This setting has been a significant driver of the sharp decline in rates that has pushed a large number of government bond yields to historic lows and a record amount into negative‑yield territory.

“The risk for central banks is that they are perceived as being in constant failure of their inflation target,” said Arif Husain, portfolio manager and head of International Fixed Income.

Indeed, major central banks have resumed monetary policy easing this year, yet inflation expectations have continued to fall. For example, the five‑year, five‑year forward—a key gauge of future inflation expectations followed by central banks—has declined below 2% in the U.S., while a similar measure for the eurozone has fallen to an all‑time low.

Opening Quote The risk for central banks is that they are perceived as being in constant failure of their inflation target. Closing Quote
— Arif Husain Portfolio Manager and Head of International Fixed Income

“Markets are painting a bleak picture for the inflation outlook, which is worrying central banks as they already used an arsenal of tools over the years attempting to revive it,” said Mr. Husain. “From interest rate cuts to bond buying and cheap lending to banks, central banks have done as much as they can. It’s now time for governments to step up to help stimulate the economy.”

On that note, there has been a noticeable change in the political tone around the use of fiscal policy to boost growth. In the U.S., the Republicans and the Democrats have both set out fiscal stimulus agendas ahead of the presidential election next year. Meanwhile, in Europe, Italy is pushing for fiscal latitude, while both France and, more recently, Germany are warming to the idea of loosening fiscal discipline.

Opening Quote If governments commit to materially boosting fiscal spending, there could be some growth and inflation pickup in the next few months. Closing Quote
— Arif Husain Portfolio Manager and Head of International Fixed Income

Turning attention to China, expectations were high at the start of the year that there would be a repeat of the massive stimulus program launched in 2015. This proved to be a strong catalyst for a revival in the global economy that year. So far, stimulus measures have not materialized to the same degree, with spending much smaller and more targeted this time around.

“If governments commit to materially boosting fiscal spending, there could be some growth and inflation pickup in the next few months,” said Mr. Husain.

Such an environment could be conducive for the reflation trade, a scenario whereby bond yields and risk assets rise at the same time. In that scenario, U.S. inflation‑linked bonds offer a good way to support a fixed income portfolio, the team noted. “Buying U.S. inflation linked bonds right now is effectively a call option on the reflation scenario.”

Over the short term, however, a material pickup in inflation seems unlikely. For bond markets, the absence of price pressures should continue to be supportive as central banks will be encouraged to keep monetary policy accommodative. Local debt of emerging market countries, in particular, stands to benefit in this environment. “Countries like Indonesia continue to offer attractive return potential as local inflation should remain contained,” Mr. Husain concluded.

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This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

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