Investors should prepare for a world of higher price growth in the years to come, which will eventually force central banks to lift their inflation targets to 3%, according to a portfolio manager at Newton Investment Management.
Paul Brain said in an interview that he’s readying his funds for an era of more entrenched price pressures due to factors such as de-globalization and the costly fight to slow climate change. While many inflation-protected securities are already at attractive levels, concerns about tightening credit conditions and a looming recession could prompt them to cheapen further, he said.
“We are doing work looking at where we can get cheap long-term inflation protection,” said Brain, head of fixed income at Newton, which manages $100 billion in assets. “You have to get the timing right on those because breakevens could go below 2% or 1% if we go into recession.”
The US five-year breakeven rate — a gauge of medium-term inflation expectations — is currently around 2.5%. Newton plans to gradually add inflation hedges over the next three to six months as central bank credibility has been tested around the globe, with price growth rocketing to record levels in the wake of the pandemic and Russia’s invasion of Ukraine.
A 2% inflation rate has been enshrined in past decades as a goal for developed economies, helping to keep long-term expectations largely anchored. Lifting it would be a turnaround for the Federal Reserve, the European Central Bank and the Bank of England, and could come as a shock to investors betting that policymakers remain committed to easing price pressures back to this level.
Brain says the Fed and BOE are more likely to increase their targets, while ECB members may resist more due to differences in local economies.
Newton’s call comes after former International Monetary Fund chief economist Olivier Blanchard argued central banks should shift their targets to prevent restrictive monetary policy pushing economies into deep recessions.
Critics say changing the target could damage the institutions’ credibility, destabilizing markets and economies as longer-term inflation expectations ratchet higher. Former US Treasury Secretary Larry Summers has said that hotter inflation could trigger a more severe recession further down the line.
Newton’s Brain thinks it’s a matter of timing it correctly. In his view, the best moment to change the target would be in the midst of a recession when inflation expectations would be dropping quite sharply.
He pointed to when central banks adjusted their frameworks, with the ECB adopting a symmetric target of 2% in 2021 and the Fed moving to flexible average inflation-targeting the year prior. These had little impact on markets, Brain said, given that price growth at that time was well below the target.
While revising inflation targets up can potentially cause volatility and push longer-term bond yields higher, not doing so can also damage central banks’ credibility, if they were to consistently miss their goals, Brain said.
“We would have to go back to be being scared about duration,” he said.
This article was provided by Bloomberg News.