We expect annual growth in the U.S. consumer price index (CPI) to average in the range of 2.5% to 3% between 2025 and 2030, as the chart shows. This is broadly consistent with inflation moderately above the Fed’s 2% target (CPI inflation tends to run above the Fed’s preferred gauge based on the personal consumption expenditures, or PCE, price index), and a jump from current market-implied inflation. Rising global production costs are the trigger. The Covid shock is driving up costs in contact-intensive services, and could speed up deglobalization and the remapping of supply chains for greater resilience against a range of potential shocks. Less offshoring could give domestic workers more bargaining power on wages, especially in places where the political pendulum is swinging toward addressing inequality. So-called superstar companies – many in the tech sector – could gain greater ability to pass on higher production costs to customers, having achieved dominant market shares.

Major central banks are evolving their policy frameworks and explicitly aim to let inflation overshoot their targets. After having persistently undershot its inflation goal, the Federal Reserve has adopted a new policy framework to deliberately push inflation above target to make up for past misses. The central bank also said it will be concerned only by the “shortfall” from full employment, with tight labor markets no longer a consideration. With the help of higher production costs, we expect the Fed to succeed in lifting inflation above 2%. The Fed essentially has given up two key reasons to raise rates that it previously had: inflation on track to overshoot the target and overheated labor markets. This reinforces our views about upside inflation risks –especially with rising political pressure to keep interest rates ultra-low.

The third force is the joint monetary-fiscal policy revolution we have just experienced – a necessary response to the Covid shock. We see a risk scenario where major central banks lose grip of inflation expectations relative to their target levels. This is not our base case – but could happen without proper guardrails and a clear exit plan from current stimulus measures. The blurring of fiscal and monetary policy means the decision to start tightening monetary policy will be more politicized. Significantly higher debt loads mean debt servicing costs will rise when monetary policy is tightened. The less tangible – but no less real – risk of loosening the grip on inflation expectations may be more politically appealing. On the flip side, a premature withdrawal of fiscal support — a risk we see in the U.S. – could forestall the reflationary path that is our base case.

Our inflation outlook represents an important shift in the economic backdrop for investing. Higher inflation is not yet reflected in market prices, opening a window of opportunity for long-term investors. Once higher inflation appears, it’s likely too late for investors to react – markets will have already moved to price in higher inflation expectations. In unconstrained portfolios, we are overweight inflation-linked bonds and underweight developed market nominal government bonds on a strategic basis. Building inflation protection comes with a cost when there is little inflation around, but it’s less costly now as the ballast role of nominal government bonds has diminished with their yields near effective lower bounds. We also like real assets, such as real estate, as potential diversifiers and sources of resilience. Selected equities may provide some inflation protection as well, complementing less liquid inflation-linked bonds and real assets. We prefer companies with strong market positions and the ability to pass on higher costs.