Interest Rates and Inflation Expectations
In our last forecast, we discussed the recent rise in global inflationary pressures. These pressures reflect emergence from the global recession of 2001-2 and monetary and fiscal laxity in several of the world's largest economies, as well as rising commodity prices and temporary factors such as indirect tax increases in some countries. While none of these pressures have eased, and some such as rising commodity prices have intensified, recent indicators suggest that inflationary expectations have actually come down over the past quarter. The downward drift in inflationary expectations has been accompanied by a drop in long-term interest rates. This means that we have not seen the rise in real long-term interest rates that our model simulation of a permanent oil price rise predicts. In fact, real long-term interest rates have actually come down slightly since July. The positive stimulus to demand from low real interest rates largely offsets the negative impact of rising oil prices on growth in the major economies. This is particularly true in the US, where low bond yields stimulate mortgage refinancing and consumer demand.
While monetary authorities in the US, the UK and Canada have been raising short-term interest rates in recent months, long-term government bond yields have been falling and we explore some possible explanations in this section. Falling long rates during a monetary tightening cycle are a very" unusual occurrence, as long-term interest rates should reflect the expected path of short-term interest rates over the future. The drop in 10-year government bond yields, therefore, suggests that the average expected short-term interest rate over the next 10 years has come down. This is reflected in a flattening of the yield curve for short-term interest in the US, Canada and the UK since July, as the pace of monetary tightening is expected to be slightly more measured than previously forecast.
Our interest rate forecasts are reported in Table 2. Our short-term interest rate projections follow financial market expectations implied by the rates of return on assets of different maturities. Our long-term interest rate projections move in line with a 10-year forward moving average of these short-term interest rates. Chart 5 shows the short-term yield curve for the US, along with a 10-year forward moving average of this yield curve. From this chart it is clear that long rates are expected to rise gradually over the next several years. The downturn in long-rates witnessed this quarter is, therefore, expected to be a temporary dip, with rates expected to revert to their upward trend by the end of the year. …