Taking the ‘flationary temperature

Tom Traill - 21 June 2017

The interplay between inflation and real output growth can have huge implications for portfolio allocations and subsequent returns. Continuing our series of blogs on stagflation, this one tackles the issue of classification of economic history into its various states.

When presented with a long run time series of real growth and inflation it can be relatively easy to pick out some periods that clearly illustrate one state or another: reflation (a nominal expansion that is shared between its activity and price components); disinflationary growth (the coincidence of rising  economic growth and falling inflation); stagflation (the combination of rising inflation with falling growth); and deflation (the coincidence of falling growth and inflation rates). However, there are also slices of economic history that seem indeterminate, oscillating between states.  

Seeking to resolve these ambiguities, we have derived a classification process that allocates each quarter-year to one of the four states, and thus eliminates any subjective bias that might otherwise arise. There are many factors to consider in formulating this classification process: the relative magnitudes of the activity rate and the inflation rate; whether the nominal growth rate is rising or falling; the relationship of the series to their respective long-term averages and the significance of departures from them; and in what direction and how rapidly are inflation and real output growth changing?

In this approach, it is necessary to define the what is meant by ‘rising’, ‘falling’ or ‘steady’, as applied to CPI inflation and real GDP growth rates. This requires that we navigate the issue of blips – sudden changes of pace that immediately reverse – and set a threshold of change that marks the transition between ‘steady’ and ‘rising’ or ‘steady’ and ‘falling’. This task was much more difficult than it initially appeared! Once we had devised a formula that overcame the most serious objections, we applied it consistently across the different countries and global aggregates. The long-term chart for Malaysia is shown as an example.

Over the past 35 years, despite its status as an Asian tiger, Malaysia has spent around a quarter of the time in each state. Stagflation is not just a freak occurrence from the 1970s. There are plenty of times when growth is stagnant or falling and inflation rising concurrently. The inflation and growth stories are sufficiently distinct to define all four logical combinations as regular occurrences. Disinflationary growth is the sweet spot for real equity returns and real bond returns tend to be attractive also. The transition to stagflation is a perilous for both asset classes, but most obviously and consistently for bonds – government and corporate.

A dangerous myth has captivated bond-land: that inflation is self-regulating. In other words that any upward drift in inflation will stunt aggregate demand and the inflation will be quickly extinguished. There are many historical episodes when this has not happened, when stronger nominal growth has coincided with softening real growth. The stagflationary threat is real and already gives an accurate portrayal of certain large advanced economies.

Figure 1

Data source: CEIC, Thomson Reuters Datastream and EP calculations


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