investment viewpoints

When the disinflation ride gets bumpy

When the disinflation ride gets bumpy
Florian Ielpo, PhD - Head of Macro, Multi asset

Florian Ielpo, PhD

Head of Macro, Multi asset

The spectre of inflation re-emerged at the start of this year, particularly in the US. While we are not suggesting a surge in inflation recalling the increases of 2021 and 2022, it must be said that long-awaited disinflation is unlikely to occur in a straight line. This week, Simply put investigates the roots of a mini-resurgence in price rises.


Need to know:

  • The period of double-digit inflation from 2021-2022 is well and truly over: disinflation is underway
  • However, breaking down the inflation cycle into sections with different frequencies reveals that some inflationary pressures persist
  • What is prompting these pressures, and how could monetary policy be impacted?


What’s driving inflation?

The first wave of inflation in 2021 was rooted in the reopening of a world hooked on stimulus, with government deficits reaching levels not seen since the late 1970s. Recently, US inflation reports have again started to surprise economist expectations to the upside, in line with the message from our inflation nowcasting indicator (shown at the end of this article).

Amid volatile inflation, rather than looking at the 'quantity', or level, of inflation, it makes more sense to us to consider its 'quality', or origin. The first wave of inflation reflected a negative supply shock, accompanied by a sharp rise in production costs. What could be the source of a temporary second wave of inflation?

This week, Simply put explores the different frequencies of inflation – and finds that the value of a good old-fashioned trend/cycle decomposition should not be underestimated.


Hodrick and Prescott forever

Trend/cycle decomposition is one of the forgotten statistical techniques of the 1990s. At the time, the field of economics was trying to organise ideas and explore history with new techniques such as the decomposition of economic series into trends and cycles.

Hodrick and Prescott presented a statistical method for breaking down a time series into a 'trend' component that was structural in nature, and the fluctuations surrounding this trend, or the 'cycle'. A useful tool to study the history of economic fluctuations, techniques of this kind use a smoothing parameter to carry out the decomposition, a parameter that has caused ample discussion in the academic research.

Depending on the intensity of this smoothing, the analyst can extract economic series from cycles that are longer or shorter, exhibiting more or less long periods. When applied to the consumer price index series, the choice of a multitude of cycle frequencies can help answer our question: what type of factor drives disinflation and what about the other factors driving inflation as a whole?


Disinflation through costs

Figure 1 breaks down inflation in the US, the eurozone and China into three components: a very long-term component (high smoothing), a medium-term component (medium smoothing) and a shorter term component (low smoothing). The chart shows that the short-term component (ST) was particularly positive during the first oil shocks – in 2008 when oil was hovering above USD 100 and in 2022. This component, therefore, seems more linked to cost-push inflation shocks, which are essentially the cost of raw materials. It is a key driver of Chinese inflation, which is further evidence of its link to costs.

The medium-term component (MT), on the other hand, took prominence mainly in the US and particularly during the major demand-led inflation shocks of the late 1970s and 2022-2023. Finally, the chart illustrates the 'long' trend in inflation, which reflects more structural factors such as demographics, productivity and the regionalisation that has been sweeping the world since 2018.

FIG 1. Historical breakdown of inflation by area

Source: Bloomberg, LOIM at February 2024. For illustrative purposes only.


Inflation, round two

Figure 2 summarises the message conveyed by the last observation in this decomposition: if inflation has fallen recently, it is essentially due to the component that appears linked to costs. The demand component is only falling in China, not in Europe or the US. The long-term trend, as measured by this Hodrick and Prescott decomposition, is still pointing to inflation remaining above 3%.

FIG 2. Breakdown of inflation components by area

Source: Bloomberg, LOIM at February 2024. For illustrative purposes only.


So, if there is a 'round two' of inflation, it is likely to reflect demand factors rather than supply factors. This could lead central banks to continue exhibiting caution and postponing rate cuts.


Simply put, inflation could well remain above central-bank targets for a few more quarters – as long as demand remains supportive.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:

  • Growth continues to improve in the three zones tracked by our indicators, crossing the crucial 45% threshold between a slowdown and growth being at potential
  • Our inflation indicator remained stable this week, continuing to show that disinflation is becoming less pronounced
  • The Federal Reserve and the People’s Bank of China are in dovish territory, while the European Central Bank retains a neutral stance

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)


Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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