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23.01.2017 | 13:15

UBS: What if inflation bounces higher?

The recent election of Donald Trump (along with potential implications of fiscal spending and corporate tax cuts) has triggered revision of inflation expectations on a broader scale. The question is whether the inflation risk is underestimated and how to inflation-protect portfolios.

Over the past years a number of economic events including, amongst others, the Financial Crisis of 2007–2008, the European Sovereign Debt Crisis of 2011–2012, through to the recent Oil Price Drop in 2015, have led inflation expectations to low levels. Despite massive monetary stimuli, inflation figures have generally remained low with little indication of rising attempts. Figure 1 illustrates U.S. inflation with the current Fed target rate near zero level and inflation below the 2% target. Communication from the U.S. Federal Reserve, and other central banks, has not been able to lift market’s inflation expectations for an extended period of time. The U.S. post-crisis inflation averaged 1.4% from October 2008 to October 2016 compared to the long-run average of 4.1% (from January 1971). The most common explanations for lower inflation include weaker growth globally, falling energy prices, stronger dollar as well as the structural impact of technological progress.

However, Figure 2 shows FOMC members’ inflation projections for the coming years, indicating a major change is anticipated in the U.S. inflation, from actual downward sloping to expected upward trending. Furthermore, Donald Trump’s win (along with potential implications of his fiscal policy plans) as well as the December FOMC guidance that have triggered revision of inflation expectations on a broader scale. What if Donald Trump implements the fiscal spending of USD 1 trillion? Could inflation overshoot?

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