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Inflation Expectations Are Higher – and Will Probably Keep Rising

We see reasons why the current monetary and fiscal policy rhetoric may support higher inflation.

Breakeven inflation rates have ticked up in recent months. But is this a temporary phenomenon, or the beginning of a more persistent trend? While PIMCO expects inflation pressures to remain relatively subdued, we see a few reasons why the current monetary and fiscal policy rhetoric are likely to support higher inflation.

Cracks in the old theories

The post-crisis reconstruction of the financial system that began over a decade ago has yielded mixed results globally. Risk assets clearly experienced a renaissance of sorts as investors strove to keep up with even modest price appreciation in a zero to negative interest rate regime. However, central banks, armed with tools to influence financial markets rather than the “real economy,” were unable to deliver the levels of inflation – and the associated benefits – that their models had indicated. Income inequality gaps have broadened precipitously, and many wonder if the Phillips curve (which postulates an inverse relationship between inflation and unemployment) is broken, as global unemployment reaches new lows.

Doubts about central banks’ ability to produce inflation on their own, along with concerns about the fragility of the architecture used to engineer the financial markets’ reconstruction, raise a deeper question. Is inflation support solely a monetary phenomenon, or does it need reinforcement from somewhere else?

It doesn’t feel like a stretch to say that with technological advancements and globalization, many of the closed-system theories and formulas trusted by academics are no longer achieving their expected results. The need to go beyond the standard toolkit of policy actions with extraordinary measures during the crisis was the first evidence that the models may be out of date. Recognizing this, Federal Reserve officials recently announced plans to formally review the Federal Open Market Committee (FOMC)’s monetary policy strategy, tools, and communication practices, with announcements to come in 2020.

Potential outcomes favor higher inflation

While PIMCO and most Fed watchers do not expect a radical change in the Fed’s approach, we think its tone will likely be supportive of a higher inflation environment. This is in contrast with previous strategy reviews, which have focused on suppressing inflation.

Meanwhile, calls for coordinated fiscal and monetary policy – including, at the extreme, the emergence of Modern Monetary Theory (MMT) amid rising populism – have become much more frequent.

We believe positioning for potential higher inflationary outcomes is attractively priced in the context of these realities. Among the potential outcomes is an approach in which the Fed lets inflation run above target temporarily, while fiscal policy continues to be accommodating. Given that neither of the major U.S. political parties appears to be striving for austerity, we will be watching for potential increases in fiscal spending, regardless of who is in power, in an effort to promote sustained and higher growth and thereby boost the neutral rate of interest (r*). This scenario, too, would be a departure from historical norms: Monetary policy typically has served as a counterbalance to fiscal expansion, to prevent excess.

Key takeaways

We believe that whether the Fed takes a new approach on its own or we see a more coordinated government approach, both scenarios are fraught with execution risk. At a minimum, including these scenarios in the range of reactions raises the number of potential higher inflation outcomes.

A rise in inflation expectations is one logical market reaction to the potential for Fed and fiscal policy shifts, and we have indeed seen an expansion of breakeven inflation rates so far this year. Some of the rise likely reflects recovery from a painful December, which means the 20-basis-point move in 10-year U.S. Treasury breakevens in 2019 to date could just be the beginning.

For more of our views on how inflation, interest rates, and Fed policy are moving markets, see our latest Cyclical Outlook, “Flatlining at The New Neutral.

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Steve A. Rodosky

Portfolio Manager, Real Return and Long Duration

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London
PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

Dublin
PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
Limited
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+49 (0) 89 26209 6000

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PIMCO Europe GmbH - Italy
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+39 02 9475 5400

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Tel: + 41 44 512 49 10

PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. BR022803) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 15 of the Securities Institutions Act (WplG). The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.

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