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●   At the turning point: After four decades of declining inflation, the tide is turning in the advanced world. Several cyclical and longer-term structural factors suggest that underlying inflation will rise in the coming years. Markets have begun to sniff out the increase in price pressures – Chart 1. Once the pandemic that is still holding back economies starts to fade, the extent to which inflation will rebound and the reaction by central banks to it will likely turn into the top issue for markets.

●   More inflation: good or bad news? A gradual return of inflation to central bank targets of c2% can be neutral or even mildly positive for the economies and real assets such as equities. Central banks could then slowly scale back their stimulus without jeopardising the economic recovery. However, a sustained rise in inflation beyond levels that central banks are inclined to tolerate would force them to step firmly on the brakes eventually. High financing costs and the subsequent plunge in economic growth would be a recipe for a major selloff in equity markets.

●   Reasons for optimism: At least for 2021 and 2022, we expect the benign scenario to prevail. Not even the US Fed, which is facing the biggest challenge due to an outsized US fiscal stimulus, will need to throttle growth. Until the healing of labour markets has progressed sufficiently, central bank policy decisions will remain skewed to the dovish side. Bond yields look set to rise visibly, but not (yet) to an extent that would materially retard the economic recovery in the next two years.

●   Back to the old normal: After the pandemic, the advanced world can gradually return to the pre-Lehman normal: less subdued inflation, faster gains in GDP per capita and productivity as well as higher central bank rates and bond yields.

●   Implications for financial markets: The adjustment back to the old normal will not be smooth. But central banks will try to minimise the risk of a new “taper tantrum” by providing clearer advance guidance on their intentions than the Fed had done in 2013. Over time, the return to stronger growth momentum may limit the extent to which central banks may be concerned about market corrections – less of a Fed put.

●   The tail risk – return to the 1970s: The inflation and growth outlook resembles the 1994-2007 period and represents a major improvement over the past decade. While some observers worry that the future will be more like the high-inflation 1970s, we do not see this as a serious risk. Central banks will not repeat that mistake.

Holger Schmieding

Chief Economist

+44 7771 920377

holger.schmieding@berenberg.com

Kallum Pickering

Senior Economist

+44 20 3465 2672

kallum.pickering@berenberg.com

Disclosures

This material is intended as commentary on political, economic or market conditions for institutional investors or market professionals only and does not constitute a financial analysis or a research report as defined by applicable regulation. See the "Disclaimers" section of this report.

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