Still, we don’t expect a material increase in inflation in 2021. As we’ve learned in recent years, output gaps and inflation expectations offer only incomplete explanations of the inflation process. But COVID-19 has boosted spare capacity, and inflation expectations are near record lows. Notwithstanding some supply-side scarring, this combination presents a formidable hurdle to a near-term acceleration in inflation.
To be clear, we still think the pieces are falling into place for the shift to a higher inflationary regime, but we’re probably not there yet—especially if the US drags its heels on fiscal policy.
Can Bond Yields Stay So Low?
Which brings us to the burning question: What will happen to bond yields in 2021?
We’ve noted before that the world has entered a new era of central banking, one in which monetary policy’s overriding objective is to facilitate fiscal expansion by pinning bond yields at ultralow levels for the foreseeable future. We call this relationship “joined at the hip.”
This view will be tested as growth recovers. After all, aren’t bond yields unnaturally low? And don’t they always rise during upswings in the business cycle? Maybe. But there are three important counters to this line of thinking:
1. Given current debt levels, interest rates are pretty much where they should be; a sharp rise would call debt-sustainability into question in a number of countries.
2. Even before COVID-19, this wasn’t a normal cycle, a key example of this being a breakdown in the relationship between unemployment and inflation.
3. We’ve entered a new monetary/fiscal policy regime, in which many of the old rules are unlikely to apply.
Central bankers are unlikely to describe their actions using our joined-at-the-hip framework—though the European Central Bank (ECB) has come close, suggesting that it needs to keep interest rates low to prevent fiscal expansion crowding out private-sector spending. Instead, they continue to anchor their actions in a conventional policy framework, by describing them as a shift in the reaction function aimed more squarely at delivering higher inflation.
Either route ends up in much the same place, though. The equilibrium interest rate is significantly lower than it used to be. And in the absence of compelling evidence that inflation has shifted durably higher, monetary policy won’t respond to higher growth and falling unemployment in the same way that it did in the past.
There are some easier and harder calls to make here.
There is, for example, virtually no scenario in which the world’s major central banks will raise policy interest rates next year. Likewise, it’s hard to see Japanese yields rising now that yield curve control is firmly cemented. And while the ECB has not yet formally adopted yield curve control, it is doing much the same thing in practice and simply can’t afford anything beyond a modest increase in core or peripheral bond yields.
The US Federal Reserve’s (the Fed’s) task is likely to be tougher, partly because the US bond market has not yet internalized the possibility that current yield levels might be “normal.” But the Fed has been very explicit about its new reaction function and its intention to run the economy hot in order to stoke inflation. Absent an increase in actual inflation or material shift in inflation expectations, it won’t have much tolerance for higher yields.
That doesn’t mean that US yields won’t rise next year. But it does mean that a return to pre-crisis trading ranges is unlikely. The Fed may be tested next year, but if it is, an old adage springs to mind: Don’t fight the Fed.