By Jonathan Kearns, Ph.D., Chief Economist and Head of Regulatory Affairs, Challenger
Inflation is back in the spotlight. After the post-COVID surge, inflation remains front of mind not only for households and businesses but also for central banks, banks and investors trying to assess what it means for asset prices, interest rates and risk.
But inflation itself is not the main concern. Rather, unexpected inflation is the real problem.
Inflation and financial markets are tightly entwined. Inflation directly affects asset returns and drives monetary policy, which then feeds back into markets. But inflation itself is not the main concern. Rather, unexpected inflation is the real problem. Asset prices reflect the expected value of future cash flows; investors care about the real purchasing power of those cash flows, and so they incorporate expected inflation. When inflation is higher than expected, and cash flows do not adjust, an asset is worth less.
The recent inflation shock was a sharp reminder of the effects of unexpected inflation. In 2022, inflation in the United States peaked at 9 percent, far above the 2.3-percent expected rate reported one year earlier in a Bloomberg survey. Around the world, the highest inflation rates in decades blindsided markets and policymakers. The causes are by now familiar: highly expansionary fiscal and monetary policies designed to insure against the worst outcomes of a once-in-a-century pandemic; vaccines and economic resilience that released pent-up demand against still-disrupted supply chains; and an energy-price spike following Russia’s invasion of Ukraine.
This episode demonstrates that the successes achieved by inflation-targeting central banks in recent decades should not breed complacency. Inflation shocks still occur, and when they do, they move markets.
Why unexpected inflation hurts
Inflation disrupts economic activity, especially when it is unexpected or volatile. Supply-driven inflation is particularly damaging because it combines weaker output and profits with higher prices. Demand-driven inflation is also problematic, but at least it is accompanied by some strength in economic activity.
Unexpected inflation forces costly adjustments. For example, fixed tax thresholds interact awkwardly with rapidly changing prices and values. Lower-income households, with smaller savings buffers, are hit harder. And even once inflation falls, the price level remains high, and incomes can take years to catch up (Figure 1). Inflation uncertainty also makes businesses and investors more reluctant to commit capital.
How inflation weakens asset returns
The transmission to asset prices is powerful. Inflation weakens activity, lifts nominal interest rates and pushes central banks to tighten policy. Greater uncertainty can also raise risk premia. Asset prices then face a double hit: lower expected cash flows and higher discount rates.
Nominal bonds are the most obvious casualty. Their fixed future payments lose value as inflation rises, and longer-term bonds suffer most because more of their value lies in payments far into the future.
Equities are no safe harbour from unexpected inflation, at least in the short term. High inflation slows growth, squeezes profitability and raises discount rates, all of which weigh on valuations. United States data dating back to the late 1800s show that high inflation tends to coincide with low equity returns. Returns recover over time, but the recovery typically takes years.
Commodities and real assets, including property, are often described as inflation hedges. There is logic to this. Food and industrial commodities feed directly into the consumer price index (CPI), while some property rents are indexed to inflation. But the hedge is imperfect. Not all real assets generate cash flows that fully compensate for higher inflation, and a weaker economy still hurts demand and valuations. Losing less than other assets is scant consolation for investors facing weaker portfolio returns.
Inflation drives monetary policy
Most central banks operate flexible inflation targeting, setting their policy interest rate to return inflation to target within a reasonable timeframe, subject to the secondary objective of achieving full employment. However, central banks can differ in how they balance inflation and employment, and how quickly they seek to rectify deviations of inflation from the target.
The challenge for inflation-targeting central banks is that monetary policy affects demand with a lag. Forecasts are therefore central to policy decisions. Expected inflation matters most because it can become self-reinforcing: Workers seek larger wage increases; businesses build more indexation into contracts; and higher inflation becomes entrenched. Persistent deviations of expected inflation from the central bank’s target are, therefore, especially troubling and usually elicit a stronger policy response.
Despite its importance in monetary-policy decisions, inflation is hard to forecast. Outcomes depend on uncertain forces, including inherently unpredictable human behaviour. The history of the Reserve Bank of Australia’s (RBA’s) forecasts since 1993 shows the median error for two-year-ahead inflation is almost one percentage point.
That uncertainty is why central banks pay close attention to other projections, particularly those from well-informed financial markets and participants.
Viewing inflation through markets
Financial instruments allow central banks, banks and investors to observe aggregate inflation expectations in real-time. These market-based measures are especially useful when inflation risks are moving quickly, such as during oil-price swings related to the conflict in the Middle East this year. Financial-market measures are also available across different horizons, helping reveal whether markets expect an inflation shock to fade or persist.
One measure involves comparing yields on nominal bonds with those on inflation-indexed, or “real”, bonds. Real bonds index principal to CPI inflation, so the difference between real and nominal yields implies a “break-even” inflation rate: the rate at which investors would be notionally indifferent between holding nominal and inflation-linked bonds. But break-even rates are not pure inflation expectations. Indexed bonds are less liquid than nominal bonds, so the yield difference includes an illiquidity premium. It can also include an inflation-risk premium to compensate investors for the risk that inflation deviates from expectations. Both premia can move over time and can be correlated with market sentiment.
Zero-coupon inflation swaps offer another market-based measure. In these contracts, one party pays realised inflation over the life of the swap, while the other pays a fixed rate agreed upon at inception. They are used by participants with future payments or receipts linked to inflation, including infrastructure investors hedging inflation-linked revenues and pension funds hedging indexed obligations. Pension funds tend to dominate long-dated demand, while hedge funds are more active in short-dated swaps. Dealer banks provide a link, intermediating across different maturities.
Swaps avoid the direct liquidity comparison between real and nominal bonds, but they have liquidity challenges of their own. Swaps liquidity can vary over time; short-dated swap rates can be particularly sensitive to liquidity shocks, and even long-dated swaps may need adjustments to better capture inflation expectations. Swaps may also be less widely traded than bonds, so they can reflect the views of a narrower group of market participants.
Inflation swaps often outperform surveys as predictors of inflation, but they are far from perfect. (For example, one-year inflation swaps are found to be more accurate than surveys in the United States, although they can be less accurate in periods of illiquidity, such as the financial crisis and the pandemic.) Since 2007, a regression of inflation on unadjusted one-year inflation swaps explains around one-third of the movements in inflation for France, Germany and the United Kingdom. For Australia and the United States, however, the explanatory power is only about 10 percent. In Australia, once current inflation is added to the regression, the inflation swap is not even statistically significant in explaining one-year-ahead inflation.
Case study: Inflation swaps in an inflation shock
Inflation swaps have responded sharply to the evolving inflationary oil-price implications stemming from the United States-Israel-Iran conflict. During the first half of March 2026, as oil prices surged, so, too, did short-dated inflation swaps, as investors priced in higher fuel and transport costs and their pass-through to oil-intensive products (Figure 2). Swaps suggested that expected inflation in Europe in one year’s time had risen by 1.5 percentage points relative to pre-hostility levels. In Australia and the United States, the increase never exceeded one percentage point.
At first glance, these relative moves are surprising. Fuel has a larger weight in the consumer price indices of the United States and Australia, at 3 and 3.4 percent, than in the three European countries, where it is 2.4 to 2.7 percent. The United States and Australia also have larger oil-, gas- and coal-extraction sectors, meaning an energy shock is less contractionary and therefore less deflationary for the economy overall. European countries also have higher fuel taxes, which tend to dampen the pass-through of oil-price increases to retail petrol prices. But the inflation response depends on exchange-rate movements, second-round effects on other CPI components and expected fiscal and monetary policy responses.
While the spot oil price climbed as high as 70 percent above its pre-conflict level, the average of the first 12 monthly contracts was more stable, at around 30 percent above the pre-conflict spot price (Figure 2). Because oil-price pass-through to inflation tends to be rapid, the average expected oil price over the next 12 months is more relevant to inflation in one year’s time. While the pass-through from an oil-price shock to inflation depends on whether it is a supply or demand shock and on general economic conditions, an expected inflation increase of 0.75 to 2 percentage points in response to a 30-percent expected increase in future oil prices is broadly consistent with elasticities reported in the literature of 0.2 to 0.5.
The episode also exposes the limits of market pricing. The one-year, one-year forward inflation rate, derived from one- and two-year inflation swaps, represents expected inflation over the 12 months starting in one year’s time. For Australia, this rate was essentially flat throughout the episode, even as comparable forward rates elsewhere moved with oil prices (Figure 3). The most likely explanation is a lack of trading in Australian inflation swaps, especially at the two-year horizon. The broader lesson is clear: Just because a price appears on Bloomberg does not mean it contains useful information.
Lessons for banks and investors
Inflation cannot be ignored. Inflation significantly affects asset returns directly and through the monetary-policy response.
The post-pandemic episode has delivered a blunt message: Inflation cannot be ignored. Inflation significantly affects asset returns directly and through the monetary-policy response. For banks, inflation and interest-rate dynamics affect trading books, loan performance, funding costs and balance-sheet management. Market-based measures of inflation expectations can provide valuable information for financial markets, banks and central banks. But they must be read carefully. Liquidity, risk premia and market structure can distort the signal. The right lesson is not to ignore market-based inflation expectations, but to critique carefully the information they convey.
Dr. Jonathan Kearns is the Chief Economist and Head of Regulatory Affairs at Challenger and an Adjunct Fellow at Macquarie University. He spent 28 years at the Reserve Bank of Australia (RBA), including leading its climate-change work, and also worked at the Bank for International Settlements (BIS). He holds a Ph.D. from the Massachusetts Institute of Technology (MIT).