Inflation in the major economies is heading higher in 2021. The Fed knows that. The ECB knows that. Our forecasts have inflation in both the US and eurozone and most of the G10 getting closer to inflation targets and even rising above them. We believe US headline inflation is set to rise above 3% and core PCE above 2% by mid-2021. Oil, food, shipping costs, some temporary bottlenecks and a very low pandemic-inflicted base in 2020, explain much of the anticipated rise. The key question is whether the inflation rates reached around mid-year will be the peak or the beginning of a lasting trend of higher inflation rates?

Our forecasts for 2022 do not point to a sustained acceleration in inflation: inflation expectations are structurally low, with US 10Y breakevens just a bit above 2%.

Elevated unemployment rates mean a revival in labour’s pricing power is unlikely.

The medium-term outlook for inflation is less clear cut. One upside risk we have highlighted before is that higher wages become mandated by governments. Now President Biden plans a federal minimum wage rise, although we expect that it might have only gradual and mixed effects over time. The ability for firms to raise output prices – rather than raise productivity, squeeze profit margins or automate more jobs – would depend on the underlying strength of consumer demand across the economy.

Another risk is that higher inflation unfolds as a consequence of a policy error. If policymakers underestimate the permanent damage to aggregate supply from the pandemic and stimulate aggregate demand too much – resulting in what is typically described as a positive output gap – then inflation could follow. But, estimates of the ‘output gap’ are unstable and unreliable in real time and central banks cannot be confident of the demand or supply outlook when so much depends on how the pandemic pans out domestically and globally over the next six months.

Given the broader disinflationary pressures that have weighed on US inflation over the past quarter-century, the Fed is much less focused on such measures of slack in the economy and even the unemployment rate. Its average inflation targeting (AIT) framework gives it the flexibility to be very patient in waiting to see a sustained rise in inflation before raising rates. Dependent on widespread, effective distribution of COVID-19 vaccines and an acceleration in economic growth through the middle of this year, we think the FOMC will start tapering its asset purchases at the end of 2021 as long as risk assets do not come under pressure.

For most other G10 central banks, it is abundantly clear that they are still some way from scaling back the monetary support as they expect inflation to be far too low.