Why inflation forecasters and bond markets are split

As we pass halfway through the third year of the post-pandemic markets regime, many questions remain unanswered. Some of these go to the heart of how markets and entire economies operate. How high will inflation go, when will cash rates peak, what can we expect from growth going forward?

Inflation forecasts are the numbers that economists produce for where they expect inflation to be in the near term, usually over the next one to two years. For long-term bonds this average expectation for inflation might be for the next 10, 20, or even 30 years., and each are important in their own way for the setting of monetary policy.These inputs are also instrumental in shaping the market’s view on expected returns. Higher inflation will require higher returns to compensate. This in turn necessitates lower asset prices and/or higher earnings.

Market practitioners fare little better in inflation expectations, or other market pricing. Large corrections to financial market prices are a seemingly permanent feature of markets and bear testament to that. Put simply, does it matter that long-term inflation expectations are low and stable, if we know that they will probably be wrong? And if they are wrong, does this expose markets to even greater shocks in future?

On this basis, perhaps stable inflation expectations are enough, even if the poor short-term inflation forecasting track record would suggest otherwise.

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