Although there is still no strong consensus as to how inflation will play out when economies re-open, financial markets may be overestimating how long inflation will persist, argues Vanguard’s Sarang Kulkarni.
Kulkarni, who manages the $421m Vanguard Global Credit Bond fund, explained that whilst there could be a short-term spike in inflation, he does not believe it will persist for as long as being currently priced by the bond markets. 
“If you look at bond markets [inflation] is being reflected already,” he said. “If you look at inflation expectations in the US, they are over 2.25 per cent, in the UK they are well north of 2.5 per cent.
“These are 10-year average expectations, so people are already pricing in a return to higher inflation.”
This implies investors are pricing inflation to remain quite high for the foreseeable future over the next five to 10 years, not just the next six months or next year.
“We just don't see the ability of the economy to be able to stay in such high levels of inflation for so long,” the Vanguard portfolio manager said.
This is because high levels of inflation will have the negative effect that central banks do not want to see.
“People will stop spending, people will hold back on future expenditure because of inflation worries, or supply might be constrained to where companies might not actually release goods right now, so they might not produce goods now,” Kulkarni (pictured) explained.
In an inflationary environment, companies may be discouraged to produce goods only to sell them at a lower price when they could produce them a year later and probably sell them 5 per cent higher.
“So high inflation has this negative impact on fundamentals on the economy, that at some point will have to be addressed, which is why you won't have persistently high inflation,” he continued.
“They [central banks] will be probably tolerance for inflation in the short term, but they won't let it persist.”
Whilst the US Federal Reserve has indicated that it will be tolerant of inflation running slightly higher than its targets, its priority is seeing the economy come back to normal levels.
“That's really where the vaccination programme is the big X factor,” Kulkarni said. “If the vaccination programme is as successful as people expect, or even more successful than people expect, then you will see that return to normalcy happening sooner rather than later and central banks would have to act faster than people expect.
“If the vaccination programme is not as successful as people expect, and the economy is not recovering as fast as people expect, what you might see is inflation expectations start to fall.”
How inflation plays out is therefore more dependent on how successful the vaccination programmes are and, given the staggered progress across countries, it is hard to predict the exact timeframe of its success.
Another reason why long-run inflation fears could be overblown is down to what it implies in terms of how sustainable the economic growth will be off the back of pent-up demand.
Kulkarni said: “Once people get over the initial rush of pent-up demand, going out and spending, travelling, going back into work again, you have to think about what is the sustainable rate of growth for the economy?
“That itself has a big influence on inflation as well.”
He questioned whether the economic activity would sustain higher levels of inflation once pent-up demand is fully exhausted.
Additionally, investors should not discount the impact of the secular factors that are driving inflation down.
“All of these factors will come back into play once we go back to normalcy, and they will be exerting this downward pressure on inflation,” Kulkarni added.
These factors include globalisation, automation, demographics in the west and the role that technology plays in being able to deliver goods and services cheaper.
The Vanguard portfolio manager also pointed the current state of real yields on US 10-year Treasuries, which are currently negative.
10-year Treasury Inflation-Indexed Security
Source: Board of Governors of the Federal Reserve System (US)
He highlighted the difference in yields between the US 10-year Treasury bond and the US 10-year inflation-indexed Treasury bond, which is north of 2.25 per cent.
“This kind of tells you that people expect to be paid for at least 2.25 per cent inflation over the next 10 years, per annum,” he said.
“In a way, it's sort of saying the Fed will be tolerant or they've relaxed their inflation target for the next 10 years, which is kind of contrary to this normalisation theme.
“If things are going to go back to normal, why would the Fed relax their inflation expectations for 10 years? You can expect them to do it for a short time, maybe a year, maybe two years, maybe three years, but why would they relax it for 10 years if we are going to go back to normal?
“So something's got to give. Something has to change as we go down this path of normalisation.”
One thing he expects to see change as the economy starts to normalise is the real yield on Treasuries - that are currently negative - go back into positive territory.
“In the past pre-Covid you'd see real yields at 10 years in the US be somewhere around like 0.5 per cent positive, so when we go back to normal, you should expect that to come through.”
Kulkarni manages the Vanguard Global Credit Bond fund which has delivered a total return of 20.27 per cent since inception in 2017, versus 12.64 per cent from the Bloomberg Barclays Global Aggregate Credit benchmark and 8.13 per cent from the IA Global Bonds sector average.
Performance of the fund since inception
Source: FE Analytics
The FE fundinfo four crown rated fund has an ongoing charges figure (OCF) of 0.35 per cent.