Cyclical outlook

Dealing With an Inflation Head Fake

The global economy is poised for a strong rebound, but investors should beware of market volatility stemming from pronounced inflation fears.

The Author

Joachim Fels

Global Economic Advisor

Andrew Balls

CIO Global Fixed Income

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Investors should be prepared for an inflation "head fake" and look to maintain portfolio flexibility and liquidity to be able to respond to events in what is likely to be a difficult and volatile investment environment.

These are two of the key takeaways from our latest Cyclical Forum and strategy meetings, in virtual format again but bringing together the whole of PIMCO's global team of investment professionals. Our economic teams laid out the baseline forecast for a strong recovery across the world and inflation that – in spite of all the reflationary talk – we think is likely to remain below central bank targets over the next one to two years, notwithstanding a temporary spike over the next several months (which could cause a "head fake" in markets). We will lay out that baseline and the risks around it below.

But, those forecasts aside, our forum discussion often returned to the potential for financial markets to maintain focus on inflation risks, at a time when central banks globally have pledged to go very slow and when fiscal policy, this year at least, should boost growth – with a very big boost indeed in the U.S.

We have seen a sharp rise in bond yields, albeit from low levels, and a rise in volatility. The front ends of yield curves have tested, a little at least, the thesis that central bankers will hold their nerve and stick to their long-term patient planning. It is quite likely in our forecasts that the coming near-term rise in inflation won't be sustained (see Figure 1). But it also seems quite likely that financial markets will continue to remain focused on upside inflation risks in the near term and that volatility will continue to be elevated, compared with recent history at least.

Figure 1: PIMCO forecasts a bumpy near-term path for U.S. inflation

Figure 1 is a line chart showing U.S. CPI (consumer price index) inflation from December 2016 through February 2021, and PIMCO forecasts for U.S. CPI through December 2022. Both headline and core (ex food and energy) inflation measures touched multi-year lows amid the pandemic in 2020. PIMCO forecasts a temporary spike in both measures in mid 2021, with headline inflation estimated to reach 3.5% year-over-year, and core 2.0%, before both measures moderate later in 2021 and through 2022.