The great market gamble: bond yields and inflation targets

Ultra-low bond yields could be construed as indicative of markets gambling against central banks’ commitment to inflation targets. Bondholder losses could be large if inflation targets are achieved, and catastrophic if inflation targets are raised (and ultimately hit). Higher targets are unlikely, but should remain on markets’ radar, given the impact.

If inflation targets remain a credible anchor for inflation expectations at longer horizons, this implies real rates for bond yields are currently negative across a very wide range of economies. Based on 10-year bond yields minus countries’ inflation targets, 12 have real interest rates in the region of -2% (including Switzerland and Germany, but also the Czech Republic and Slovakia).

Real rates are so extraordinarily low that reversals appear inevitable at some point. Oxford Economics’ baseline remains that major economies achieve close to targeted inflation five to 10 years hence, and that real rates will not be strongly negative for a decade. But the timing of zero-rate escapes is a major conundrum of our era.

A benign view

Markets are taking a benign view of various risks to their lower-for-longer baseline for bond yields, including the possibility that (i) the doom loop between banking sector and government problems re-emerges; (ii) governments could struggle to fund promises inherent in current social security programmes; (iii) regulatory pressure for institutions to invest in government bonds could reverse; (iv) emerging market demand for Western government bonds – sustained by their perceived relative safety compared to emerging economy alternatives – will be maintained.

Markets may also be taking a strong view that central banks will take a very long time to reach their inflation targets. Neither economic theory nor recent history provide a good guide as to how long it might take to escape the sustained period of close-to-zero rates. More than 25 years on, Japan has still not recovered from its late 1980s credit crunch, while US and UK interest rates have already been at the effective lower bound for more than seven years (since early 2009).

Former US treasury secretary and economist Larry Summers recently questioned whether it is possible for any single economy to escape alone via the use of monetary policy. One way of interpreting current yields is that markets have almost fully priced in Mr Summers’ arguments.

Benefits outweigh costs

Employing higher inflation targets is a still-unused tool in central banks’ toolkit and one that would be very costly for bondholders; we are persuaded that the benefits of increasing inflation targets outweigh the costs.

An important advantage of a higher inflation target is that it provides greater scope for stabilisation policy to absorb negative shocks. With the US Federal Reserve now arguing the neutral Fed funds rate is 3% (1 percentage point above its inflation objective), this leaves too limited scope for rate cuts before policy runs into zero-bound issues.

Higher inflation targets could be useful even as policy-makers struggle to meet existing (lower) targets. The key is to distinguish short- and long-run objectives and specify the long-term target to form a realistic transition path where both can be achieved.

This is exactly how most countries’ inflation targets started out in the 1990s. Short-run ‘targets’ were hybrids that in some ways were more like forecasts than targets, but were nevertheless successful as a transparency device. The Bank of England’s initial 1992 inflation targets reflected that approach “with a target range of 1% to 4% and the intention that it should be in the lower half of that range by the end of that parliament [1997]”.

In practice, higher inflation targets are unlikely, particularly in the next five years. The Fed would be extremely wary of inviting more scrutiny by the legislature of its mandate and its policies. A 4% target for the eurozone would stretch to breaking point the European Central Bank’s mandate to pursue “price stability”. In the UK there are no signs of senior policy-makers wishing to engage with the issue.

Longer term, the possibility of higher inflation targets is great enough to stay on markets’ radar. The long-time inflation target pioneers at the Reserve Bank of New Zealand could take the lead. Over very long horizons we attach a probability of a higher inflation target being announced of, say 10% to 20% in the UK, 5% to 15% in the US, and 1% to 5% in the eurozone. A credible 1% increase in the inflation target could, if it fed through to bond yields, imply UK long-dated gilt prices fall by more than 15%, with even bigger losses for Switzerland, Germany and Japan.

It all appears rather worrying for global bond investors, but we have some sympathy with a common riposte frequently heard nowadays: “So what else should I invest in?”

Gabriel Sterne is head of global macro research at Oxford Economics. Tony Yates is professor of economics at the University of Birmingham and a consultant to Oxford Economics.