Even Central Bankers Can't Agree on Reflation

(Bloomberg Opinion) -- Investors are betting that as vaccines cure the pandemic, the recovery in growth will be fast and straightforward. That optimism, with the built-in assumption that prices are bound to recover too, has sent bond yields up around the globe. But two recent speeches by policy makers at the Bank of England, and their flagrant disagreement over the outlook for inflation, should give bondholders pause.

Monetary Policy Committee member Gertjan Vlieghe said on Feb. 22 that “tightening too soon would be a worse mistake than tightening too late.” Four days later, fellow rate-setter Andrew Haldane begged to differ. “For me, there is a tangible risk inflation proves more difficult to tame, requiring monetary policy makers to act more assertively than is currently priced into financial markets,” he said. They can't both be right.

While the worldwide jump in bond yields was triggered initially by rising Treasury yields, gilts have moved more than their non-U.S. peers. By mid-week, the 10-year U.K. government borrowing cost was up by more than 40 basis points in the month, double the increases seen in the French and German markets.

With more than 30% of its population having received a first vaccination shot, compared with just 5% in Germany, France and the European Union as a bloc, Britain's prospects for coming out of lockdown quickly with an accompanying economic rebound certainly seem to look brighter than for its neighbors.

But are the U.K.'s higher yields justified by the outlook for inflation? Sure, consumer prices are expected to increase in the coming quarters. But economists expect that following months of below-target increases, the shift higher will arrive slowly and fade quickly.

Moreover, the range of the Bank of England's projections for inflation in two years' time “are currently twice as large as normal,” as Haldane pointed out. Unhelpfully for bond investors, the central bank calculates that there's a one-in-three chance that inflation will be double its 2% target, and a similar likelihood that it will be below zero. 

A side-by-side comparison of last week's speeches illustrates how the two policy makers are reaching widely different conclusions from similar economic evidence. The divide is unusually stark. 

Haldane points to the pent-up demand that may be unleashed. By mid-year, as much as 400 billion pounds ($560 billion) of household and corporate savings, swollen during lockdown, could be “seeking a new home” and available to spend on goods, services or physical and financial assets. That would deliver “a very significant degree of additional demand stimulus to an already rapidly recovering economy,” he warned.

For Vlieghe, the key is that wealthier families have benefited most. The top 20% of households by income increased the amounts they were able to put aside each month, while the bottom 40% saw their savings diminish. Those richer households “tend to have a lower propensity to spend,” he said. In other words, don't expect a spending boom.  

The pair also disagree on what will happen to wages. Haldane argues that the combination of a smaller population (as many as 1.3 million people may have left Britain in the past year as the pandemic prompted repatriations) and a shrinking workforce (as the proportion of retirees increases) is likely to lead to higher wages. That will turn “the demographic tailwinds of the past decade into a headwind” that will amplify inflation, he said.  

Vlieghe points to pay settlement surveys suggesting that wage increases will slow to about 2% this year, down from 3% in recent years and “close to where they were in the long period of weak wage growth after the financial crisis.” A further drag would come if furloughed workers can't rejoin the workforce once the support ends. In his view, that will keep “wage pressure too low” for inflation to return to target.

While the economy could bounce back faster than is currently anticipated, Vlieghe says, “There is also the possibility of a weaker scenario, and my own view is that risks remain skewed in this direction.” Haldane disagrees: “My judgment is that the risks to inflation are skewed to the upside, rather than being balanced.”

Given the uncertainty created by the pandemic, it's little wonder that different interpretations of the same data are possible. “It is something that reasonable people can disagree on,” as Vlieghe put it.

But if central bankers, who have access to the most detailed and up-to-date information on how the economy is faring, can't agree on what the likely outlook for inflation is, how can the mere bond trader be expected to parse the data? Until the economic fog lifts, the sidelines might be the safest place to be in fixed-income markets.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mark Gilbert is a Bloomberg Opinion columnist covering asset management. He previously was the London bureau chief for Bloomberg News. He is also the author of "Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable."

©2021 Bloomberg L.P.