Assistant Professor Carolin Pflueger’s New Research Provides Real-Time Indicators for “Good” and “Bad” Inflation

In a new working paper “Inflation and Asset Returns” released by the Becker Friedman Institute, Assistant Professor Carolin Pflueger reviews how current inflation dynamics compare to those seen in the 1980s and the 2000s. With inflation rising in the past few years, Pflueger and her coauthor Anna Cieslak (Duke) provide a framework to classify the nature of inflationary episodes, which allows us to ask whether the current bout of inflation resembles more closely the “bad” inflation in the 1980s or the “good” inflation of the 2000s, with implications for investment returns.

Over long periods, the yields of long-term Treasury bonds, which move inversely with prices, are clearly influenced by inflation. The intuition is simple: When you expect inflation to erode the real value of your dollars you require a higher return on an investment that promises a fixed dollar amount, such as a Treasury bond. On the other hand, the relationship of inflation with stocks is not so clear.

During the 1980s, stocks and bonds were positively correlated. This resulted in "bad" inflation where both lost value at the same time. During the time of "good" inflation of the pre-pandemic 2000s, however, stocks and bonds were negatively correlated. When inflation devalued the bonds in a portfolio, the value of stocks rose at the same time, protecting the investor’s overall portfolio.

The research then links this finding from financial markets to the observation that different types of inflation have different effects on the economy. During most of the 2000s, an increase in demand-driven inflation was viewed as helpful for the economy, and the stock market tended to rise whenever inflation depressed the value of nominal Treasury bonds. By contrast, the 1980s saw “bad” inflation due to supply shocks, which tended to occur together with high levels of unemployment and also lingered around for longer.

What does this mean for the current bout of inflation? “By looking at the correlation between bonds and stocks, you can figure out what financial markets think,” she said. “This allows us to assess whether the current environment is like the bad inflation scenario in the 1980s or more like the good inflation scenario in the earlier 2000s.” A second indicator is the inflation risk premium that investors require for bearing “bad” inflation risk, i.e. inflation compensation in financial markets versus the expected inflation from surveys.

Maybe surprisingly, both indicators – the bond-stock correlation and the inflation risk premium from swaps – do not indicate severe risk of “bad” inflation. One possibility explored in Pflueger’s working paper “Back to the 1980s or Not? The Drivers of Inflation and Real Risks in Treasury Bonds” is that the current conduct of monetary policy is viewed as less likely to generate a deep recession from supply shocks than in the 1980s. Different from the 1980s, financial markets therefore currently put a lower weight on the worst-case scenario of high inflation and protracted, high, unemployment.

“It’s still a problem, of course. We don’t like inflation,” Pflueger said, “but financial markets appear to expect a less 'bad' inflation scenario than during the 1980s. If you are an optimist, you may be relieved that the risk of 'bad' inflation in financial markets remains small. But if you are a pessimist, you might worry that markets are slow to update and in for a surprise.”