Inflation will likely rise in 2018 because its link with economic activity is stronger than many have estimated, according to AXA Investment Managers.

The persistently low U.S. inflation rate in the recent past has caused concern among policymakers. Notably, the Federal Reserve Chairman Janet Yellen last year described the situation a mystery as the U.S inflation rate stayed below the FOMC’s target of 2 percent, despite eight years of economic recovery.

“The point is that as the U.S. economy expands, disinflation pressures that were active between 2012 and 2016 will dissipate,” explains Jonathan Baltora, Portfolio Manager in the Fixed Income team of AXA Investment Managers (AXA IM).  “It is likely that it took some time to purge the imbalances and high unemployment that followed the Great Recession but we may now be seeing more inflation,” says Baltora.

“Looking at the relationship between the U.S. output gap, as estimated by the OECD, and Core CPI (Consumer Price Index), the message is clear to us; the correlation may not work in the short run but is very valid over the long term,” he adds.

Policymakers often use potential output to gauge inflation. All else equal, if actual output is greater than potential production, prices will begin to rise in response to demand pressure, leading to inflation.

A recent research paper1 published by the Federal Reserve Bank of San Francisco (FRBSF) examined the factors that have kept inflation low. In the report, the FRBSF economists classified inflation into two categories: “cyclical inflation,” which is sensitive to the economic cycle and “acyclical inflation” that isn’t.

“Cyclical inflation has been rising, which was to be expected, demonstrating that textbook economics, showing a relationship between unemployment and inflation, is still working,” says Baltora.  What was dragging inflation was the acyclical part of inflation, which was caused by federal government and legislation, like Obamacare, that aimed to lower government payments to doctors and hospitals. “We expect the recent fiscal reforms in the U.S. slowly to push prices for health insurance higher leading to further normalisation of inflation,” says Baltora.

As oil prices are trending higher, Baltora also thinks this will help normalise conditions for higher inflation.

Rising inflation could cause the Federal Reserve to raise interest rates at a faster pace. In February, bonds and equities were sold off following a report that U.S. core Consumer Price Index posted its biggest gain2 in nearly a year.

“The recent increase in market volatility following a strong wage inflation report in the U.S. demonstrates how markets have become sensitive to inflation as an investment theme,” observes Baltora.

So what does it mean for investors? In such an investment environment where future inflation is priced into the inflation bond market below the current level, adding inflation-linked bonds into their portfolios, he thinks, may offer potential benefits.

Issued mainly by sovereign governments, such as the U.S. and the UK, inflation-linked bonds are indexed to inflation, and as such the principal and interest payments rise and fall with the rate of inflation.

When is a good entry point to invest in inflation products? Some investors decide to buy when inflation is rising but it might be too late.

People have been investing looking in the rear view mirror because inflation has been disappointing in the past, they’re upset and don’t want to be holding it. But actually this may be a good  moment to be holding those bonds .

How do investors select the type of inflation-linked products? “Depending on investors investment horizons and tolerance to volatility, a wide range of strategies can be implemented in this space,” explains Baltora.

For instance, an “all maturities” approach to inflation-linked bonds will maximise inflation-linked income but would be subject to a higher sensitivity to interest rates. On the other hand, investing in shorter maturities inflation-linked bonds would secure an inflation-linked income with less volatility and income, but the performance profile would be closer to inflation itself. Finally, those seeking more aggressive returns can opt for inflation breakeven strategies that would perform when inflation expectations widen, he adds.

As inflation normalises, there is a good chance that monetary policies would normalise. Against this backdrop, Baltora believe inflation-linked bonds present an attractive diversification tool for investors.

To understand more about AXA IM’s inflation-linked strategy, please visit .

1 Federal Reserve Bank of San Francisco (FRBSF)’s Economic Letter, as of 27 Nov 2017.

2 Reuters, as of 12 Jan 2018.

Sources: AXA IM as at February 2018

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