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Global: Fears of policy-induced inflation are exaggerated

The scale of the recent monetary and fiscal policy loosening around the globe has led to growing concerns about a resurgence in inflation. However, we think the risks of a policy induced period of well-above-target inflation are small and we expect central banks will continue to undershoot their inflation targets.Evaluating the optimal policy response is challenging because of the huge levels of uncertainty. However, the likely deep economic contraction and the weakness of inflation over the past decade suggest that policymakers should err on the side of providing too much rather than too little support.The risk that central banks are overreacting has also been reduced by the declining effectiveness of policy rate cuts. Likewise, quantitative easing over the past decade has failed to generate a build-up in inflation, and we are sceptical that the reaction of inflation to the latest asset purchases will differ.Though fiscal policy has been loosened substantially, reflecting the severity of the shock, the policy measures are mainly akin to one-off measures to support firms and households through the lockdown period. Once emergency assistance is no longer needed, the fiscal support will fade. In this sense, the fiscal support is different to loosening in the form of, for example, a tax cut. Even if we are wrong and inflation does begin to pick up, central banks can reverse their unconventional policy measures or increase policy rates. In the medium-term, there is a theoretical risk that governments could take the unorthodox step of loosening the fiscal taps while preventing monetary policy from being tightened. But we think the risk of such an outcome is low and hasn’t been raised by the recent turmoil.

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