Our view on inflation

Many fear a substantial increase in both inflation and interest rates in the coming years. There is a lot at stake, specifically for investors who have a relatively large percentage of their portfolios invested in (non-inflation linked) bonds.

We do not think that there will be a major acceleration of prices or rates. In our main scenario we expect a gradual increase in inflation rates towards a cyclical peak of around 2.5%.

Our analysis of the inflation drivers does not point to rapid price advances as longer-term deflationary forces remain in place. We see sufficient arguments for a modest rise in global inflation over the next year or so.

However, we hold the view that cyclical pressures will remain controllable as the economy still has considerable amounts of unutilised resources, most notably in the labour market and in the industrial sector.

This view is further supported by the presence of strong productivity growth, the spread of fierce competition in domestic and export goods markets into the non-traded goods sector, confidence in central banks, low inflation expectations (although they are rising) and the high return on capital compared to cost (which encourages heavy investment which, in turn, boosts potential growth).

As long as the threat of protectionism, the reintroduction of restrictive labour market practices or the abandonment of competitive policies remains distant, and as long as central banks react as we expect, any cyclical rise in inflation is likely to be muted.

We expect a period of above-trend growth will eliminate some of the slack in the economy, causing the cyclical peak in inflation to remain quite low.

In this light one might expect a 'normalisation' of interest rates as well. Given a normalisation of the nominal short rates to 4%, based on 2% inflation and 2% real Fed rates and a normalisation of the yield curve, we expect fair value 10-year yields to move towards 5.5%.

This view is close to that taken by the futures markets, which has set the ten-year one-year forward rate at 5.3%. To accept that core scenario at face value however would be irresponsible.

Given the stakes, and given that an investment outlook is really a probability distribution of possible scenarios, we would consider it wise for investors not only to focus on what is most likely to happen but also on what could happen. Our alternative scenarios are:


An overheating scenario, in which inflation and interest rates rise on the back of strong growth. Such a scenario is plausible if employment trends improve dramatically and labour market slack disappears.


A stagflation scenario, with rising inflation, rising interest rates and weak growth. This might emerge in the case of a severe oil shock, leading to a shortfall in demand.


A disinflation scenario, with declining inflation, falling yields and marginally slower growth.