Looking through different lenses The scale of the economic rebound unfolding in many parts of the world has been far more rapid than anyone expected a year ago. Key has been the scale of policy support and the development of vaccines that are now being rolled out at an accelerating pace. But if growth has lurched higher, so too has inflation in many places. And it is inflation – how high will it go? and will it be temporary? – that is currently obsessing financial markets and central bankers alike.

A year ago there was common ground among central banks about how to respond to the pandemic: turn on the liquidity taps. That is no longer the case. They are going their different ways. Some central banks have already seen enough, raising policy rates in some emerging economies and starting to taper asset purchases in some G10 ones. Some are much more cautious, perhaps mindful of having tightened prematurely in the past. And in a few cases, markets are asking how many more overshoots in inflation they are prepared to look through before taking action.

All eyes on the Fed It is, of course, the Fed that matters most for global financial markets – and if anyone doubted that they had only to see the market reaction to the June FOMC meeting when it took its first hawkish turn, with a signal of slower asset purchases ahead and an indication, via the “dot” plot, of two possible rate rises in 2023.

This message came from the one central bank that has been explicit in adopting a new monetary regime of average inflation targeting (AIT) since last August. That shift was all about avoiding getting stuck at zero interest rates like the Bank of Japan or ECB. To be credible in this new framework of being willing to make up for previous shortfalls in inflation by moderately overshooting 2% for a period, the Fed has had to effectively signal that it is willing to take a risk of even higher inflation – but only to a point. This is not a policy of benign neglect.

Now the economy has rebounded strongly, the US has recently registered some of the biggest upside surprises to inflation in the world and inflation expectations are now just about where the Fed wants them to be. If they rise too much further, the Fed has just signalled it is prepared to act. For financial markets, the issue is simple: will the Fed be able to generate a soft landing or will there be a policy error? Tightening too soon or too late would have very different impacts on the dollar and other asset prices.

Big growth and inflation risks Currently, the Fed still believes the jump in US inflation is transitory and that, as temporary factors linked to the opening up of the economy abate, it will fall again. But as Fed Chair Jerome Powell has said, there is no template to guide policymakers out of a pandemic and they need to be humble about their ability to interpret the data. This holds for all policymakers, not just the Fed.

The economic rebound in many countries may have been more rapid than feared a year ago, but there are still many risks to the outlook for both growth and inflation. COVID-19 remains the biggest downside risk: until vaccines become more widespread around the world and the risk of new variants dwindles, some countries will face restrictions on domestic mobility and disruptions to activity. Globally, any activity that involves people crossing international borders will also be severely restricted. On the flip side, the biggest upside risk is still a more rapid drawdown of the huge stock of savings accumulated over the past year. That could mean a much stronger consumer rebound, adding to the demand pressures on inflation.

There are many more uncertainties, though. How much will fading fiscal stimulus slow activity?

Will housing market booms gently deflate or prompt more macro-prudential measures? How much will economic reopening slow production and trade in goods as services rebound? Or will the anticipated rebound in capital spending keep capital goods exports supported? And what will the next phase of the recovery mean for different commodity prices and terms of trade in key producing countries? How much clarity will there be on labour markets by the end of the year? Will the worker shortages – particularly acute in the lowest-paid sectors – abate once the support schemes end around September time even in countries dependent on immigration? Or will a broader rise in wage growth add to the inflation risks?

Even once these factors have played out, the pace of the bounce-back in 2021 tells us little about the implications for medium-term potential growth, any more than what happens to prices as economies re-open tells us anything about the medium-term outlook for inflation.