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26 Feb 2021

Did the world just get inflated?

By Catherine Mann, chief global economist for Citi The signposts are clearly pointing to an inflationary environment but is it time to respond?

Signs of inflation are coming up everywhere. In the United States, stronger than expected Producer Price Index (PPI) demonstrates increases in US input costs, a clear sign of a looming inflationary environment.

But the signs are not just in the US. In the United Kingdom .the food component of the Consumer Price Index (CPI) and the Retail Price Index (RPI) has been rising, and core inflation in Japan seems set to turn positive in the near future.

Inflation pressure is also biased to upside in Latin America and Central and Eastern Europe and Middle East and Africa (CEEMEA )

A good part of these inflationary pressures are due to rising commodity prices. Energy prices have jumped up this year, food commodities continue their rising momentum, and metals have been strong since the pandemic started.

Commodity prices have been rising since March last year, and the trend is accelerating

An infographic text box explaining movement of prices for various commodities for period March 20 to Jan 21

Source: Citi Research

In 2018, our global economics team noted the correlation between inflation surprises and energy prices, albeit this was when demand was strong and labor markets were tight.

How does this impact markets?

Inflation channels to financial markets vary by asset. Signs of inflation have helped the US 10-year Treasury yield reach new highs, and historically US high yield, leveraged loans and emerging market assets all benefit from rising inflation expectations.

European inflation expectations started rising last November, but since mid-January real yields started driving a sell-off in nominal yields, and that's because nominal interest rates do not take into account inflation. In comparison real yields are adjusted to remove the effects of inflation, to give a clear cost of funds for the borrower and real return to the investor. Nominal rates are normally higher than real rates, except in times of zero inflation or deflation - so the sell-off indicates an expectation things are normalising.

Share markets tend slide as yields rise, although we are coming out of abnormal situation and impacts may be muted by the reaction of policy makers, particularly central banks.

Through the pandemic crisis central banks have remained prudent. US Federal Reserve chair, Jerome Powell's testimony to the Senate in late February emphasised the Fed would continue to provide accommodation, suggesting the rise in Treasury yields shows an improved economic outlook.

In addition, Isabel Schnabel, member of the Executive Board of the European Central Bank, also noted in late February in an interview that “we will ensure that there is no unwarranted tightening of financing conditions”.

This messaged was further strengthened by ECB Chief Economist, Philip Lane, who was recently reported by Reuters as stressing the “ECB is closely monitoring the evolution of longer-term nominal bond yields”.

It's clear the eyes of the policy makers are focused on inflationary signposts.

Wealth Solutions

This information is not advice and has been prepared without taking account of the objectives, situations or needs of any particular individuals. Any individual should consider if the information is appropriate for your own situation. Individuals are advised to obtain independent legal, financial, foreign exchange and taxation advice prior to making financial decision. Past performance is not indicative of future performance. Citigroup Pty Limited ABN 88 004 325 080, AFSL and Australian credit licence 238098.

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