CFA L3 learning notes-CME-relationship of inflation to the business cycle and the implications

LOS-explain the relationship of inflation to the business cycle and the implications of inflation for cash, bonds, equity, and real estate returns

CFA L3 learningnotes-approaches to economic forecasting

Inflation and the Business Cycle:

  • Inflation tends to be procyclical, accelerating in the later stages of the business cycle when the economy is operating near full capacity. During a recession or early years afterward, there is a large output gap, leading to downward pressure on wages and prices, which decelerates inflation.
  • If a central bank’s inflation target is credible, the average rate of inflation over the business cycle should be near the target.
  • Inflation expectations also follow a procyclical pattern, with short-term expectations closely tracking actual inflation. Long-term inflation expectations are less affected by cyclical fluctuations as long as investors maintain confidence in the central bank’s target.

Implications of Inflation for Different Asset Classes:

  1. Cash:
    • Cash refers to short-term interest-bearing instruments.
    • If short-term interest rates adjust with expected inflation, cash acts as a zero-duration, inflation-protected asset.
    • Cash becomes relatively attractive in a rising rate environment and unattractive in a declining rate environment.
    • Deflation may make cash particularly attractive when the zero-lower-bound on nominal interest rates is binding.
  2. Bonds:
    • Inflation affects bonds through discount rates (yield curve) since cash flows are fixed in nominal terms.
    • Rising inflation leads to capital losses as expected inflation components of yields increase, and vice versa.
    • In the expected cyclical range, shorter-term yields have greater price impact due to shorter duration, while longer-term yields may be more sensitive to changes in the long-run average level of inflation.
    • Persistent deflation benefits high-quality bonds by increasing the purchasing power of cash flows but can harm lower-quality debt by impairing creditworthiness.
  3. Stocks:
    • Inflation within the expected range has little effect on stocks as expected cash flows (earnings and dividends) and associated discount rates adjust with inflation expectations.
    • Unexpectedly high or rapidly rising inflation may prompt central banks to take action to slow the economy, potentially impacting stock prices.
    • Very low inflation or deflation poses a threat to asset prices and can lead to a recession. It is particularly detrimental to asset-intensive, commodity-producing, and highly leveraged firms.
    • Higher inflation can benefit firms that can pass along rising costs to consumers.
  4. Real Estate:
    • Short- to intermediate-term cash flows in real estate are influenced by existing leases, with adjustments depending on the type of real estate asset held.
    • Inflation within the expected range leads to rental income rising with expected inflation and stable asset values.
    • Higher-than-expected inflation may generate high demand for real estate, expectations of faster rising rental income, and increased property values.
    • Unexpectedly low inflation or deflation puts downward pressure on expected rental income and property values, especially for less-than-prime properties that may need to reduce rents to avoid rising vacancies.

30 Jun 2023 - by toptradeready.com