Our inflation baseline is benign. We expect the rise in inflation this year will be transitory, as the dampening forces of weak demand and demographics reassert themselves. But upside risks are sizable, and should we see a period of sustained high inflation this would spell trouble for investors.
Two factors are particularly important in assessing current inflation risks: fluctuations in key economic relationships, and hard-to-predict secular trends. On the changing strength of economic relationships, the risks of a spike in inflation this year stem mainly from higher GDP growth. Upside risks are particularly high in some emerging markets vulnerable to sharp depreciations.
We have modelled a longer-term scenario in which low labour market participation rates and rising inflation expectations combine to produce a prolonged period of above target inflation. This would be a high impact event for investors, upending the consensus view of lower-for-longer rates, high equity returns, and an investor preference for credit. No wonder investors are keen to buy protection. As for the economy, the impact is relatively small.