Pundits' skepticisms about monetary authorities' ability to harness inflation without growth recession continue to defy empirical observations and modern (common sense) economic thinking. According to our models, major economies' macro fundamentals and market pricing are consistent with more certainty about well-anchored long-term inflation expectations. To reiterate our view, this (pundits') cognitive dissonance relative to fundamentals and market pricing is driven by an obsession on the short-term effects of past monetary policies and old (pre-70s) economics theory. Instead, according to actual experience and modern economic thinking, it is the long-term expectation of real economic growth and the credibility of future policy path anchoring long-term inflation expectations that matters. Our previous note addressed the growth expectations question: there is more certainty about a slow, but improving long-term real global economic growth. This note focuses on the policy credibility and inflation expectations issue.

Exhibit 1 - Breakeven Inflation

Our starting point to gauge inflation expectations is bond market pricing. Exhibit 1 portrays the evolution, from January 2013 to October 2023, of 10-Year breakeven inflation rates (1) 10-Year breakeven inflation rates are derived as the difference between 10-Year Constant Maturity nominal and real (inflation-linked) government bond yields. for major economies. According to the Exhibit, inflation expectations implied by bond markets have remained stable overall and well below realised inflation rates over the past year. With the exception of China and Japan, though, they are still higher than central bank target rate (2) The central bank target rate is 2% for the US, Euro area, UK, and Japan. For China, the target rate is 3% (for 2023). As for India, the Reserve Bank of India has an inflation target range of 2% to 6%. . Despite this positive spread, our view is that bond markets continue to perceive future monetary and fiscal policies to be credible. A number of empirical observations lend support to this view:

• From a purely statistical standpoint, this spread is not significant when compared to the historical standard deviation of inflation rates (3) More precisely, the annualized, historical standard deviation of quarterly realized CPI inflation is about 1.7% in the US (since 1947), Eurozone economies (since 1960) and India (since 2011), 2.7% in the UK (since 1960), 2.4% for Japan (since 1960), and 2.8% in China (since 1993). .

• Spreads would have to be significantly higher to signal lack of credibility (4) In fact, our structured models allow us to evaluate what these spreads would be, conditioned on a lack of trust in monetary and fiscal policies. According to our models, even in the US, spreads would be at least 6%! .

• Breakeven inflation would also have to be at least as high as realised inflation rates.

• Finally realised inflation rates would have to continue to increase persistently. As a matter of fact, over the past year, realised inflation rates have continued to fall.

The question, then, is why would the bond market judge monetary and fiscal policies to be credible? The principal reason is that monetary authorities of these major economies are all committed to bring inflation back to their target rates. This commitment has been reflected in the significant increases in central banks' refinancing rates (5) The US Federal Reserve has already raised interest rates significantly from nearly 0% in February, 2022 to 5.3% in July, 2023 - a total of 11 hikes in 14 months). The ECB increased its refinancing rate ten times since July 2022, from 0% to 4.5% (a 22-year high). The Bank of England raised its official bank rate from 0.25% in December 2021 to 5.25% in August 2023. The Reserve Bank of India raised its key repurchase rate from 4.4% in May 2022 to 6.5% in February 2023. . Monetary authorities also strongly signalled their intention to continue to do so, following their monitoring of inflation data, and the evolution of the macro and markets environment.

Exhibit 2 - Debt-to-GDP Ratio

Moreover, these statements seem well backed by government budget constraint considerations. Exhibit 2 depicts the evolution of the debt-to-gdp ratio since 2013, for the same major economies. As shown in the Exhibit, with the exception of China (which does not seem to suffer from high inflation at this stage), debt-to-gdp ratios have declined from their pandemic induced peak level and have remained stable in the past year (6) However, current debt-to-gdp ratios remain significantly higher compared to pre-2008 GFC levels of about 67% in the US, 60% in the Euro area, and 50% in the UK. . Further expansion of (unbacked) deficit financing strikes us as politically unlikely. These government finances considerations link expected inflation levels to the expected levels of net government debt creation (including growth in the monetary base and fiscal surpluses, primarily revenues from taxes). All else equal, higher expected levels of government debt creation over time relative to expectations of future surpluses lead to higher levels of expected inflation today. What matters is the expected path of debt creation and whether it can be backed by potential future surpluses (i.e. future real economic growth), not single episodic bursts of new debt. In turn this question is closely tied to the path for real growth and real growth uncertainty.

In this context, greater certainty about slow but improving long-term growth prospects, as shown in our previous note, lends support to monetary and fiscal credibility. Said differently, these growth trends also imply greater certainty (i.e. receding uncertainty) about benign and declining inflation expectations evolving closer to central banks' target rate.

Exhibit 3 - Navega Model-Implied Long-Term Inflation Expectations

Exhibit 3 portrays the evolution of long-term inflation expectations implied by our models, for the same major economies. In the case of the US and the Euro area, our model inflation expectations have continued to decline in the past year to about 2.1%, a level barely above the central bank target rate of 2%. In the case of the UK, inflation expectations have also continued to decline, by a large margin, from their post-pandemic high of 5.6% to 2.7%. In India, long-term inflation expectations have also declined to about 4.9%, well within the target range of the Reserve Bank of India of 2% to 6% .

As shown in Exhibit 4, long-term inflation uncertainty implied by our models has been receding about these rather benign long-term inflation expectations, for all major economies except China. Inflation uncertainty (with the exception of China) is now back to pre-pandemic levels. These trends have been primarily driven by the decline in long-term growth uncertainty. In the case of China, growth uncertainty is still persistently high, as shown in our previous note. In turn, inflation uncertainty also remains high, according to our models.

Exhibit 4 - Navega Model-Implied Long-Term Inflation Uncertainty

That said, markets' (and our models') perception of policy credibility does not necessarily imply a smooth transition of realized inflation rates toward central bank target rates. Indeed, this path remains subject to the normalisation of energy prices, supply frictions, geopolitical tensions and fluctuations in the global macro and markets environment. However, the takeaway for investors is that there are opportunities in the resolution of these frictions. For example, real economic growth and growth uncertainty trends across countries have become fragmented since the pandemic. According to our models, these spreads in real growth trends, should they persist, imply further differentiation in expected inflation rates and expected asset returns across countries. We will continue to explore these trends and their investment implications in our next note.