Inflation pressures rise with commodity prices

Equity prices rose and credit spreads tightened in major advanced economies in the period from the beginning of December 2010 to the last week of February 2011. Investors priced in a strengthening of economic activity and an increasing likelihood that the recovery in those economies had finally reached escape velocity. Government bond yields also increased significantly, reflecting a combination of higher expected real yields due to anticipated monetary policy tightening and higher expected inflation. During the last week of February, however, investor sentiment changed dramatically as concerns mounted about the impact of the political unrest in North Africa and the Middle East.

The rise in inflation expectations, especially in the near term, was due not only to the stronger growth outlook, but also to rapid increases in agricultural and other commodity prices, in particular food prices. This prompted renewed concerns among investors and policymakers about the inflationary impact of higher commodity prices across the globe and possible second-round effects. Accelerating oil price increases in the wake of escalating political tensions in North Africa and the Middle East added to these concerns.

Equity and bond prices in a number of emerging market economies began to reflect increasing investor concerns about the impact of policy tightening in response to rising inflation. Moreover, the changing global outlook led investors to rebalance their portfolios geographically. This resulted in outflows from equity markets in Asia and Latin America and inflows into developed economy equity markets.