The prevailing mood in the markets is cautious optimism, with a near-universal expectation of economic rebound on the horizon. Much less agreed on, in fact quite hotly debated, are the dangers that may lurk from inflation. High inflation, or even just moderately higher inflation at the wrong time, could upset investor sentiment and drag down equity and credit markets. Inflation, or rising prices in the economy, matters because it is reflected in both the price and yield of government bonds, the so-called risk-free assets which are the starting point for judging the attractiveness and risk-reward trade-off of other assets. Any build-up of inflation expectations would lead to rising bond yields and falling bond prices. This is because rising inflation erodes the value of bonds and makes their coupons less appealing, especially longer-dated ones. Recently, yields on government bonds have been very low , and prices have been so high that investors have mostly shunned government debt for better priced equities. However, a faster improvement in the inflation outlook and higher bond yields could lead to a reversal in this trend as investors see an opportunity to pick up cheaper government bonds. Bond yields also affect equity valuations, as analysts use them to determine the value of future corporate earnings and whether a company is fairly priced. Lower bond yields mean future earnings are discounted at a lower rate and look more valuable today. If yields are higher, the reverse is true. Most major equity markets are trading at valuations well above their long-term averages. These higher valuations have been justified, given the lower bond yields and discount rates being applied. However, such lofty prices may come into question should yields rise. With inflation lagging far behind central bank targets for so long, why would it suddenly become a problem now? The answer lies in the double-barrelled policy response to the pandemic. The past year has brought very loose monetary policy and ample fiscal support as central banks tried to help global economies get back on their feet, but this has some anticipating that we might get back to pre-pandemic levels of economic activity much faster than previously thought. That would mean the spare capacity in the economy will be eroded faster, pushing inflation higher. Should this happen, one side effect could be that central banks slow or even stop their bond purchase programmes, removing a persistent source of demand. This demand has been a key reason yields have been so low. If bond purchases halt, we could see a repeat of the 2013 “taper tantrum” , when the US Federal Reserve sent shock waves through the bond and equity markets by signalling it would effectively stop printing money. The worst-case scenario is certainly possible. But it is not probable, for a few reasons. First, there is still plenty of slack in the economy, as judged by the labour market and elevated unemployment rates. The unemployment rate and the quest for full employment are key indicators for central bankers in judging the inflation outlook. When unemployment is low enough, the labour market is defined as being “tight”, and wages are expected to rise as employers compete for workers. This wage growth should drive the sustainable level of core inflation that central banks desire. However, we are some way from full employment and tight labour markets. Then there is the central bank response and the threat of a taper tantrum. After an extended period of below-target inflation, central bankers will be in no hurry to unwind easy policy at the first hint of inflation. The Fed’s average inflation targeting framework is a clear indication of a higher tolerance for an economy that runs hot and higher levels of inflation. In this regard, central banks have become much more reactive to inflation than proactive, willing to wait for sustained levels of inflation before shifting rates or shrinking balance sheets. Why the Fed’s bid to boost US inflation is good news for Asia Moreover, developed-market central banks have an incentive to keep borrowing costs low to enable the fiscal largesse that is ultimately likely to generate the economic growth and inflation that monetary policy no longer can. Finally, there are inflation expectations themselves, which are something of a self-fulfilling prophecy. If inflation expectations are low, then actual inflation often ends up being low in the long run. For example, workers who do not expect prices to be higher in the future are less likely to demand higher wages today. While an inflation spike and sharply higher bond yields would certainly derail the markets, the reality is that inflation should remain muted in the early stages of economic recovery. Kerry Craig is a global market strategist at JP Morgan Asset Management