Rob Arnott/Research Affiliates: "History Lessons: How “Transitory” Is Inflation?"

First up, from Trading Economics (also on blogroll at right), monthly CPI inflation prints since January 2020:

source: tradingeconomics.com

And from Research Affiliates, November 15: 

Key Points

• The US Federal Reserve Bank’s expectations for the speed of reverting to 2% inflation levels remains dangerously optimistic.

• An inflation jump to 4% is often temporary, but when inflation crosses 8%, it proceeds to higher levels over 70% of the time.

• If inflation is cresting, inflation levels of 4 or 6% revert by half in about a year. If inflation is accelerating, 6% inflation reverts to 3% in a median of about seven years, threatening an extended period of high inflation.

• Reverting to 3% inflation, which we view as the upper bound for benign sustained inflation, is easy from 4%, hard from 6%, and very hard from 8% or more. Above 8%, reverting to 3% usually takes 6 to 20 years, with a median of over 10 years.

Rob Arnott is the corresponding author. 

 

“Those who cannot remember the past are condemned to repeat it.”
—George Santayana

Bad news: History tells us that once the inflation genie is out of the bottle, it can take far longer to return to normal levels than most people realize. Indeed, when Federal Reserve Chair Paul Volker took office in 1979, he pushed the fed funds rate to an unprecedented 20%, 5% above the previous peak inflation rate, the equivalent of today’s Fed embracing double-digit rates. Even so, it took two more years for this extreme policy intervention to cut inflation to half its peak level (to 7%), and over six years to bring inflation to 2%. In a meta-analysis of 67 published studies on global inflation and monetary policy, Havranek and Ruskan (2013) found that across 198 instances of policy rate hikes of 1% or more, in developed economies the average lag until a 1% decrease in inflation was achieved was between roughly two and four years.

Those who expect inflation to fall rapidly in the coming year may well be correct. But, history suggests that’s a “best quintile” outcome. Few acknowledge the “worst quintile” possibility, in which inflation remains elevated for a decade. Our work suggests that both tails are equally likely, at about 20% odds for each.

When Will the Inflation Genie Go Back in Its Bottle?

To answer this question, we studied all cases where inflation surges above 4% in 14 OECD developed-economy countries from January 1970 through September 2022.¹ After a country’s inflation rate first exceeds 4%, we observe inflation’s behavior thereafter. As Neville, et.al. (2021) point out, an inflationary surge is not always a bad sign – for example, an increase from -2% to 1% may foreshadow a healthy upturn in the economy. Here, we test inflationary surges at thresholds of 4% and above, so as to exclude those cases where the economy is recovering from a bout of deflation. For each episode, we measure the time from the first crossing of the thresholds we study (4% to 20%, at intervals of 2%) until the next time inflation retreated to one of two specific targets: in the first test, halfway back to zero or, in the second test, to below 3%. We found 52 instances when inflation rose above 4% for the 14 OECD economies in our sample, of which 6 instances proceed to exceed 20%.²

“The lesson…is not that inflation is destined to move to new highs in the months ahead (after all, nearly 30% of the time, it is, in fact, cresting!), but that we dismiss that possibility at our peril.”

We observe a useful pattern. When inflation first crosses the 4% threshold, often caused by a temporary exogenous shock, it usually reverses course; in 32 out of 52 cases; over 60% of the time inflation never reaches the next threshold of 6%. We call any case where inflation fails to reach the next threshold cresting inflation. That is the good news. The bad news is at 6% and higher inflation, cresting inflation is the exception, not the rule: inflation usually marches to the next threshold. When inflation subsequently rises to the next threshold, we call these cases accelerating inflation. Indeed, once the 8% threshold is surpassed, as happened this year in the United States and much of Europe, inflation marched to the next threshold, and often well beyond, over 70% of the time.³ The lesson we should take from this is not that inflation is destined to move to new highs in the months ahead (after all, nearly 30% of the time, it is, in fact, cresting!), but that we dismiss that possibility at our peril....

....MUCH MORE 

It's been a while since we've visited Research Affiliates, they are very good at what they do.

They are a sub-advisor or strategy provider to funds betting $132 billion on RA's approach.

If interested see:   

• Research Affiliates: "The Promise of Smart Beta"
• Investing: Cliff Asness Blasts Rob Arnott
• Asness vs. Arnott: Factor Rotation Research
• "Some Cautionary Notes on Smart Beta " 
• Schwab 'Robo-adviser' Bets it All On Red, Hits, Says Let It Ride 
• Research Affiliates and The Cyclically Adjusted Earnings Yield Ratio (and its relationship to forward real returns in the market)

The last time we mentioned Rob Arnott & Company Cliff Asness was crabby:

"Investing: Cliff Asness Blasts Rob Arnott" 

This, on the other hand, seems smarter than feuding over return-factors-and-timing (we lean toward Asness) and although we can't vouch for the forecasting skill of inverting Shiller's CAPE it's an interesting idea....

 

Actually, we have so many posts on Arnott that it is probably easiest to do a Google search of the blog:

site:climateerinvest.blogspot.com robert arnott