FEDS Paper: “Good” Inflation, “Bad” Inflation: Implications for Risky Asset Prices
Publication Date: January 6, 2025
Authors: Claudia Macaluso, Martin Bodenstein, and Philipp Hartmann
Abstract:
This paper examines the distinct effects of “good” inflation, driven by strong economic growth and rising productivity, and “bad” inflation, caused by supply shocks or excessive monetary expansion, on risky asset prices. The authors argue that these different types of inflation have contrasting implications for economic fundamentals, risk premia, and asset valuations.
Key Findings:
- Good Inflation: Moderate and stable inflation accompanied by robust economic growth and productivity gains tends to support risky asset prices. Improved corporate earnings, increased consumer spending, and positive market sentiment contribute to higher equity and bond valuations.
- Bad Inflation: High and volatile inflation driven by supply shocks or monetary policy errors negatively impacts risky asset prices. Economic uncertainty, reduced corporate profits, and diminished purchasing power lead to increased risk premia and lower asset valuations.
- Implications for Investors: Investors should differentiate between the types of inflation when making investment decisions. Exposure to risky assets can be increased during periods of good inflation, while caution is advised during episodes of bad inflation.
- Policy Considerations: Monetary and fiscal policies should aim to foster good inflation and mitigate bad inflation. Central banks can use interest rate adjustments to influence inflation expectations and stabilize economic growth. Fiscal policies can address supply-side constraints and promote productivity.
Detailed Analysis:
Good Inflation
- Improved Economic Fundamentals: Strong economic growth leads to increased corporate earnings, higher employment levels, and improved consumer confidence.
- Lower Risk Premia: Stable inflation reduces uncertainty and makes future cash flows more predictable, leading to lower risk premia on risky assets.
- Increased Asset Valuations: Positive economic sentiment and ample liquidity drive demand for risky assets, pushing up valuations.
Bad Inflation
- Damaged Economic Fundamentals: High inflation erodes consumer purchasing power, reduces corporate profits, and distorts economic signals.
- Increased Risk Premia: Inflation volatility raises uncertainty and increases the cost of capital, leading to higher risk premia on risky assets.
- Lower Asset Valuations: Negative market sentiment and reduced investment appetite drive down asset valuations.
Conclusion:
Understanding the distinction between good and bad inflation is crucial for investors and policymakers. Good inflation can be a positive force for risky asset prices, while bad inflation poses significant risks. Investors should adjust their portfolios accordingly, and policymakers should prioritize policies that foster economic stability and mitigate inflation risks.
FEDS Paper: “Good” Inflation, “Bad” Inflation: Implications for Risky Asset Prices
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