Not all inflation is created equal. While the high inflationary period of the 1970s and 1980s was marked by stock market lows not seen since the Great Depression, recent upticks in inflation have been met by rising stock values. How stocks comove with Treasury bonds has shifted over time as well. These inconsistencies present a challenge to investors seeking to safeguard their portfolios against risk, as well as for policymakers aiming to understand how financial markets respond to shocks. Motivated by this, this paper offers a framework for understanding the implications of inflation.
The authors distinguish between inflation that is “good” and that which is “bad,” using prior research to show how the two have different sources and implications for markets. They establish the following concerning “good” vs. “bad” inflation:
This framework can help policymakers and investors draw more accurate conclusions about the sources and consequences of future bouts of inflation. While it is still too early to predict the impacts of the post-COVID pandemic surge, evidence from surveys and inflation swap markets suggest that inflation risk premia are narrow. The authors conclude by offering two interpretations of these early indicators: that of the optimist, who may be relieved that inflation risk remains small, and that of the pessimist, who may worry that markets outpace beliefs, often slow to update.