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TRANSITORY EXPECTATIONS

I don’t know how many points the word “transitory” scores in Scrabble, but it certainly scores highly with policy makers around the world at present, particularly when they are talking of the outlook for inflation as the global economy recovers from the effects of a global pandemic.


Jerome Powell, Chairman of the US Federal Reserve is head cheerleader for the transitory inflation propo-nents and so far his words have had a soothing effect, helping to bring down the yield on the US 10 year Treasury from 1.74% at the end of March to below 1.5% by the end of June. Although the Fed confirmed in May that they had begun to “talk about talking about” remov-ing some of the extraordi-nary stimulus that they have been providing in for the past fifteen months, Powell was at pains to stress that they consider current infla-tionary pressures as being transitory and not, therefore, a reason to accelerate the withdrawal of the huge amount of liquidity in the system. His view has been echoed by other central bankers around the world, sending the inflation bears back into their caves, at least for the moment. This allowed bond markets to calm down and growth equi-ties (eg technology stocks) to reverse some of the loss-es they had made earlier in the year, while “re-opening” stocks cooled.


None of this is of itself par-ticularly worrying. Partly behind the inflation scare in Q1 was a significant rise in some key commodities (eg lumber and oil) along with supply shortages in raw ma-terials and industrial compo-nents such as steel and semiconductors. While there may be reasons to think that in at least some of those cases, price rises might last for a while, they are in es-sence changes in relative prices. Inflation is a change in the general level of prices and it is fair to say that so far, there has been little clear evidence of this. How-ever, those of us who are of a certain vintage might recall that when inflation sets in, it is usually regarded as being transitory but something helps it gradually to sustain itself until it becomes clear that there is a general rise in the level of prices and that containing that is difficult and often painful. I recall listening many years ago to Helmut Schlesinger, then the President of the German Bundesbank saying that inflation was like asparagus—you can’t always see it grow-ing but when it appears, you find that its roots are very well established.


Most forecasters appear to think that inflation will rise above the generally targeted level of 2% but not go signifi-cantly above 3-4% before returning back down to 2%. The key for interest rates is that by the time we get be-yond 3% investors still be-lieve that central banks have it under control. If not, then it is easy to argue for US 10 year bond yields at 2% or slightly higher.


The big factor that seems to be being ignored, however, is that for years, we have been living in a world of negative real rates. If inflation expecta-tions get to the point where investors once again start demanding a real return on their savings, then that will indeed be an uncomfortable transition for bond investors.

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