Maybe Not All Inflation Is a Problem

Inflation is a word that, after the last year or two, can conjure images of people running around, flapping their arms, and muttering, “ohmigod, ohmigod, ohmigod.” There’s an assumption it’s bad, although some degree of inflation is almost always in view.

A new working paper from Anna Cieslak, associate professor of finance at Duke University’s Fuqua School of Business, and Carolin Pflueger, an economist and assistant professor at the University of Chicago’s Harris School of Public Policy, suggests that there is good and bad inflation, depending on whether it comes from demand shocks or supply shocks, respectively, when looking at returns on assets.

The paper starts with the question of what drives inflation, which may seem like it should be simple, but has been a fundamental point of division among economists since the Federal Reserve first dismissed increasing inflation as “transitory.”

“The past half-century has seen major shifts in inflation expectations, how inflation comoves with the business cycle, and how stocks comove with Treasury bonds,” the two wrote. “Against this backdrop, we review the economic channels and empirical evidence on how inflation is priced in financial markets. Not all inflation episodes are created equal. Using in a New Keynesian model, we show how ‘good’ inflation can be linked to demand shocks and ‘bad’ inflation to supply shocks driving the economy. We then discuss asset pricing implications of ‘good’ and ‘bad’ inflation. We conclude by providing an outlook for inflation risk premia in the world of newly rising inflation.”

Theories and observations of how stocks and bond yields correlate have changed at various times in history. There doesn’t seem to be one approach that holds at all times.

“We have reviewed the theoretical and empirical progress made towards understanding how inflation and investor’s expectations of future inflation affect financial markets,” they wrote. “Most obviously, inflation expectations matter for assets that deliver fixed dollar payouts, like nominal Treasury bonds. However, as inflation ultimately is an endogenous variable, its asset pricing implications depend on the nature of the underlying structural shocks. The body of evidence suggests that persistent, long-lived, stagflationary shocks are costly. When inflation is of such a ‘bad’ type, as was the case during the 1980s, prices of Treasury bonds and stocks fall simultaneously, and consequently, both require a risk discount to attract investors.”

“Good” means that inflation expectations rise when the marginal utility of an additional dollar is low, while “bad” means inflation expectations rise when the marginal utility of an additional dollar is high.

As for real estate, the report makes only one mention of it and that doesn’t establish anything about how it might play as an inflation shock. However, given that much of recent inflation was due to supply shocks, it would fit into the authors’ definition of bad.