AgPa #54: Transitory Inflation

How Transitory Is Inflation? (2023)
Rob Arnott, Omid Shakernia
The Journal of Portfolio Management April 2023, URL/Research Affiliates/SSRN

Full disclosure: I am generally skeptic about macro forecasts and I don’t think statements like “We had the same situation in 1980 and therefore things will develop like XYZ.” are much helpful. In economics, two situations are never exactly the same and we humans are very good when it comes to finding patterns in essentially random data.1There are of course a few people who consistently made money from betting on macroeconomic developments (for example Ray Dalio or Stanley Druckenmiller) and I have huge respect of them. However, given how important the topic over the last years was and still is, I couldn’t resist the temptation. This week’s AGNOSTIC Paper is a little scenario analysis whether inflation was indeed “transitory” in the past.

Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.

Setup and Idea

I think the idea of this week’s paper doesn’t need much introduction. Virtually across the globe, inflation began to accelerate in the second half of 2021. The exact combination of reasons are complicated. But with the benefit of hindsight, massive policy stimulus as reaction to the COVID pandemic and a gigantic demand for goods during the lockdowns certainly qualify. Also with the benefit of hindsight, central banks massively underestimated the inflationary pressures and initially refused to raise interest rates on the premise that inflation is “transitory”.

At the time of writing this is in March 2023, interest rates rose dramatically compared to 2021 and we (fortunately) seem to have seen the peaks of inflation. However, we are still way above the 2% target and in my perception it has become consensus that we still need some more time to get back. There is no formal definition of “transitory”, but at least in my view, 2-3 years of higher inflation is more “mid-term” than “transitory”. The authors of this week’s paper show that this outcome is not surprising because inflation was quite sticky in the past…

Data and Methodology

The authors collect data of all periods where inflation increased above 4% in 14 developed countries between January 1970 and September 2022. To start with, they measure the time until inflation reaches certain thresholds (4% to 20% in 2% steps) and classify inflation into cresting and accelerating. Cresting inflation are periods where inflation fails to reach the next threshold, accelerating inflation are those where it raises to the next threshold. Finally, the authors use this data to estimate the half-life of inflation and the time until it falls to below 3%.

Important Results and Takeaways

Transitory inflation would be a historical best-quintile outcome

The authors start with the historical median for the half-live of inflation after it reached certain thresholds. Historically, for example, it took slightly more than 2 years until inflation halved after crossing 4%. If the inflation was accelerating this number increases to more than 8 years. If it was cresting, it decreases to just one year. The gray area further shows the range between the 20th and 80th percentile and clearly shows that the range of historical outcomes is quite wide. In the best cases, for example, even inflation above 12% halved in just 2 years whereas it took more than 8 years in the worst case.

Figure 2 of Arnott & Shakernia (2023).

As I mentioned in the beginning, I strongly recommend to view such results with the necessary skeptiscm. Economies are constantly changing and no historical period is exactly comparable to today. Having said that, historical data is of course the only thing we have and I think it is helpful to see how inflation behaved in the past. The key takeaway of this chart, in my opinion, is the wide range of possible outcomes under the assumption that history repeats itself.

Given that the 2021-inflation accelerated to more than 8% in the US and to more than 10% in some European countries, the historical estimate for the half-live is with a median of slightly more than 8 years not very promising. The idea that the current inflation is (or was) “transitory” is not completely out of line with history, but it would be a best-quintile outcome.

Historically, it took >5 years to get >8% inflation down to 3%

Since central banks don’t care about the half-live of inflation but target a specific number, the authors repeat the analysis for the time until inflation gets back to 3%. I don’t know why they picked 3% because this is still one percentage point above the target of most central banks, but we take what we get…

Figure 3 of Arnott & Shakernia (2023).

The picture is even more gloomy. Once inflation crossed 8 or 10%, the median time to return to 3% was about 12 years. The 20-80th percentile area ranges from 6 to 19 years. So based on this analysis, even if we get a historical top-quintile outcome, it would take until 2028 for the current inflation to come down to 3%. And this is still 1%-point above the target of price stability… I honestly hope that history does not repeat itself in this respect, but as the saying goes, hope is not a strategy and we should better prepare accordingly…

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1 There are of course a few people who consistently made money from betting on macroeconomic developments (for example Ray Dalio or Stanley Druckenmiller) and I have huge respect of them.