LGIM: Commentary on inflation and central bank policy

Mar 18, 2021

This is a commentary by Sonja Laud, Chief Investment Officer at Legal & General Investment Management (LGIM) on rising inflation and central bank policies.

Is accelerating inflation a threat to markets? If so, short or long term? What are the implications for the asset classes?

Inflation is one of the key topics that we are monitoring carefully. Our base-case scenario is that sustained inflation pressure is only likely in 2022 at the earliest. As result, we believe that central banks should be willing and able to stop yields from moving aggressively higher in the near term. This scenario would probably lead to higher equity markets and tighter bond spreads, despite relatively unattractive starting valuations. Should yields continue moving higher, one scenario is a repeat of the ‘taper tantrum’ of 2013, prompted by investor fears over the eventual withdrawal of monetary stimulus. This could lead to a similar sharp credit and equity market correction, although we presume central bankers would ultimately step in with verbal and perhaps actual support.

While we think the chances are low, a more enduring risk would be inflation becoming a near and present danger as economic data continue to surprise significantly to the upside. Here, central-bank support would likely be constrained. Such a shortening of the economic cycle could increase the vulnerability of assets that have been boosted by very loose liquidity conditions in recent months. Indeed, recent volatility in commodities, technology stocks, and even bitcoin might be a taste of things to come.

Are central banks’ moves to support economy good enough to counter the effects of the crisis? In what time horizon can we see a loosening of the measures? 

The primary response to the crisis has been fiscal. Monetary policy can do little to directly counter the virus but central banks have cut interest rates to zero and conducted aggressive asset purchase to stabilise markets, support business confidence and keep funding costs low for governments. Even with hindsight, it is not obvious what more central banks should have done. The timing of the reversal of this extraordinary monetary accommodation is mainly linked to the attainment of their inflation goals. This in turn requires a rapid recovery from the pandemic to eliminate the currently large amount of economic slack.

The promising vaccine roll out means it is possible that US growth will be strong enough for the Federal Reserve to see substantial progress to begin tapering asset purchases later this year, but interest rate increases are unlikely before 2023. Other major central banks appear even further away from meeting their targets and seem likely to lag the Fed in withdrawing stimulus.