A Peculiar Deflation Scare – September 21, 2020

The Fed this week further emphasized that interest rates will be flat near zero for many years, and there are a number of difficult-to-achieve preconditions that must be met before changing policy. Indeed, government bond markets are discounting near-zero rates for a very long time, helping to boost risk asset prices and valuations.

There is no doubt that the near-run risks are tilted more towards deflation than rising inflation, given the uncertain economic backdrop and high unemployment. However, as highlighted in a just-published report, actual inflation data do not back up the bond market’s view, which has seen real bond yields collapse deep into negative territory, and nor do longer-term inflation expectations which have rebounded solidly. Interestingly, the trimmed mean measure of U.S. CPI showed only a brief dip during the economic implosion earlier this year, followed by a modest upside breakout!

While not an imminent threat, perhaps central banks will eventually get their wish and inflation will finally move steadily higher. If so, then investors and the financial markets are in for a rude awakening.


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