Research Review | 14 January 2022 | Inflation

The Time-Varying Relation between Stock Returns and Monetary Variables
David G. McMillan (University of Stirling)
November 2, 2021
The nature of the relation between stock returns and the three monetary variables of interest rates (bond yields), inflation and money supply growth, while oft studied, is one that remains unclear. We argue that the nature of the relation changes over time and this variation is largely driven by shocks, with a change in risk associated with each variable shifting the pattern of behaviour. We show a change in the correlation between each of the three variables with stock returns. Notably, a predominantly negative correlation with bond yields and inflation becomes positive, while the opposite is true for money supply growth. The shift begins with the bursting of the dotcom bubble but is exacerbated by the financial crisis. Results of predictive regressions for stock returns also indicate a switch in behaviour. Predominantly negative predictive power switches temporarily to positive around economic shocks. This suggests that higher yields, inflation and money growth typically depress returns but support the market during periods of stress. However, after the financial crisis, higher inflation and money growth exhibit persistent positive predictive power and suggests a change in the risk perception of higher values.

Determinants of Inflation Expectations
Richhild Moessner (Bank for International Settlements)
December 2021
This paper analyses the determinants of short-term inflation expectations based on surveys of professionals, using dynamic cross-country panel estimation for a large number of 34 OECD economies. We find that food consumer price inflation and depreciations of the domestic exchange rate have significant positive effects on professionals’ survey-based inflation expectations. Moreover, core consumer price inflation and the output gap have significant positive effects.

The zero lower bound on inflation expectations
Yuriy Gorodnichenko (U. of California) and Dmitriy Sergeyev (Bocconi University)
January 11, 2022
Inflation expectations affect the decisions of households, firms, and policymakers. Expectations of negative inflation can be particularly harmful and lead to deflationary spirals when nominal interest rates are near zero. This column uses survey evidence to show that households and firms almost never expect deflation, even when it is a clear possibility. This apparent zero lower bound on inflation expectations has important implications for macroeconomic dynamics and the effectiveness of monetary policy. Unconventional policies, such as forward guidance, which aim to increase inflation expectations may be less effective when expectations are stuck at the zero lower bound.

The Impact of Rising Oil Prices on U.S. Inflation and Inflation Expectations in 2020-23
Lutz Kilian and Xiaoqing Zhou (Dallas Fed)
November 1, 2021
Predictions of oil prices reaching $100 per barrel during the winter of 2021/22 have raised fears of persistently high inflation and rising inflation expectations for years to come. We show that these concerns have been overstated. A $100 oil scenario of the type discussed by many observers, would only briefly raise monthly headline inflation, before fading rather quickly. However, the short-run effects on headline inflation would be sizable. For example, on a year-over-year basis, headline PCE inflation would increase by 1.8 percentage points at the end of 2021 under this scenario, but only by 0.4 percentage points at the end of 2022. In contrast, the impact on measures of core inflation such as trimmed mean PCE inflation is only 0.4 and 0.3 percentage points in 2021 and 2022, respectively. These estimates already account for any increases in inflation expectations under the scenario. The peak response of the 1-year household inflation expectation would be 1.2 percentage points, while that of the 5-year expectation would be 0.2 percentage points.

Measuring U.S. Core Inflation: The Stress Test of COVID-19
Laurence Ball (Johns Hopkins University), et al.
December 1, 2021
Large price changes in industries affected by the COVID-19 pandemic have caused erratic fluctuations in the U.S. headline inflation rate. This paper compares alternative approaches to filtering out the transitory effects of these industry price changes and measuring the underlying or core level of inflation over 2020-2021. The Federal Reserve’s preferred measure of core, the inflation rate excluding food and energy prices, has performed poorly: over most of 2020-21, it is almost as volatile as headline inflation. Measures of core that exclude a fixed set of additional industries, such as the Atlanta Fed’s sticky-price inflation rate, have been less volatile, but the least volatile have been measures that filter out large price changes in any industry, such as the Cleveland Fed’s median inflation rate and the Dallas Fed’s trimmed mean inflation rate. These core measures have followed smooth paths, drifting down when the economy was weak in 2020 and then rising as the economy has rebounded.

Feeling the Heat: Extreme Temperatures and Price Stability
Donata Faccia (European Central Bank), et al.
December 1, 2021
We contribute to the debate surrounding central banks and climate change by investigating how extreme temperatures affect medium-term inflation, the primary objective of monetary policy. Using panel local projections for 48 advanced and emerging market economies (EMEs), we study the impact of country-specific temperature shocks on a range of prices: consumer prices, including the food and non-food components, producer prices and the GDP deflator. Hot summers increase food price inflation in the near term, especially in EMEs. But over the medium term, the impact across the various price indices tends to be either insignificant or negative. Such effect is largely non-linear, being more significant for larger shocks and at higher absolute temperatures. We also provide simulations from a two-country model to understand the rationale behind the results. Overall, our results suggest that temperature plays a non-negligible role in driving medium-term price developments. Climate change matters for price stability.

The Rise of the Taylor Principle
Carlos Goncalves (IMF) and Bernardo Guimaraes (FGV)
December 9, 2021
We estimate the response of interest rates to inflation using data for 18 developed countries since 1915, within 30-year moving windows. Until 1972, interest rates are virtually insensitive to inflation. From then on, the interest-rate response to inflation starts to rise, and monetary policy responses get more heterogeneous across countries. In recent decades, all countries in the sample seem to abide by the Taylor Principle. We then take advantage of the observed policy heterogeneity in parts of our sample to estimate the effectiveness of the Taylor Principle. We run panel regressions of inflation volatility on the interest-rate response to inflation with country- and time- effects. We find that a stronger monetary policy response to inflation leads to lower inflation volatility.

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