- 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.
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.
(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.
“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.
“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.
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 returns as local inflation should remain contained,” Mr. Husain concluded.
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