08 Feb 2018
Inflation is taking root. Our GPS has long pointed to US core inflation rising back to the 2% level, as shown in the Each at its own pace chart (below).
We see 2017’s surprising soft patch as fleeting and expect markets to grow more confident in the inflation outlook. Why? Wages are grinding higher and one-off factors, notably an adjustment to how wireless data costs are measured, will wash out of inflation readings. As a result, we see higher US yields ahead and prefer inflation-protected bonds over the nominal variety.
BlackRock Inflation GPS vs. actual core inflation, 2012-2017
Sources: BlackRock Investment Institute, with data from US Bureau of Labor Statistics, Eurostat and Thomson Reuters, November 2017. Notes: The inflation GPS lines show where core consumer price inflation may stand in six months’ time in each economy. Core inflation excludes food and energy prices. The other lines show actual inflation as represented by the Consumer Price Index in the US and the Harmonised Index of Consumer Prices in the eurozone.
We expect modest upside in eurozone prices but share the European Central Bank (ECB)’s outlook for inflation stuck below target at least through 2019. Spare capacity still abounds in the eurozone. We see similar trends in Japan. This is why we expect both the ECB and Bank of Japan (BoJ) to keep policy loose. See Getting to inflation’s core of September 2017.
Future interest rate expectations priced by markets, 2016-2017
Sources: BlackRock Investment Institute, with data from Thomson Reuters, November 2017.
Notes: The lines are based on one-year/one-year forward overnight index swap (OIS) rates and show market pricing for short-term interest rates one-year forward in one year’s time.
US and eurozone monetary policy and rates look set to diverge. The Federal Reserve (Fed) will be under new leadership, but we see it pressing ahead with shrinking its balance sheet – and delivering its projected three 0.25% rate increases in 2018. A fourth move could come if the Fed expects tax cuts to raise inflationary pressures. Has the era of quantitative tightening – the reversal of asset purchases – started? Not quite yet. But markets will be sensitive to any early signs that the ECB or BoJ may shift policy gears.
We expect both will still be net buyers of assets in 2018, albeit at a slower pace. The ECB has signalled it will not raise rates until well after it has ended its net asset purchases. And the BoJ’s asset purchases and long-term yield targeting should stay in place – even if a new governor takes the helm in April. Markets see short-term rates in Europe and Japan staying negative through 2019. See the Slow to normalise chart (above). But anticipatory anxiety around potential policy shifts could begin stoking bouts of volatility in 2018.
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