Our view that lift-off from current low policy rates may occur in some cases only two years from now reflects, among other things, an only gradual recovery from the pandemic’s significant effect on labor markets. (My colleagues Andrew Patterson and Adam Schickling recently discussed how the prospects for inflation and labor market recovery will allow the U.S. Federal Reserve to be patient about raising its target for the benchmark federal funds rate.)
Alongside rises in policy rates, Vanguard expects central banks, in our base-case "reflation" scenario, to slow and eventually stop their purchases of government bonds, allowing the size of their balance sheets as a percentage of GDP to fall back toward pre-pandemic levels. This reversal in bond-purchase programs will likely put some upward pressure on yields.
We expect balance sheets to remain large relative to history, however, because of structural factors, such as a change in how central banks have conducted monetary policy since the 2008 global financial crisis and stricter capital and liquidity requirements on banks. Given these changes, we don't expect shrinking central bank balance sheets to place meaningful upward pressure on yields. Indeed, we expect higher policy rates and smaller central bank balance sheets to cause only a modest lift in yields. And we expect that, through the remainder of the 2020s, bond yields will be lower than they were before the global financial crisis.