Are we on the verge of an inflation regime change?

Inflation is higher than most of us can remember. But will it persist, or revert back to the lower levels we have become accustomed to for the past 40 years? Portfolio Managers Alex Holroyd-Jones and Jason Borbora-Sheen, explain why the answer entirely depends on the upcoming actions of central banks.

19 Jul 2022

3 minutes

Alex Holroyd-Jones
Jason Borbora-Sheen

19 July 2022

In politics, ‘regime change’ typically signifies one governing party replacing another; in economics, the same term is used to indicate a shift in various parts of the economic or financial system. While political regime changes are easy to identify, defining a regime change in economics can be more challenging.

Take inflation, for example. The developed world was in a structural inflation regime for a significant portion of 1948-1980, with price levels rising aggressively following the Second World War, a booming US economy from the mid- the ‘60s and the oil surges of the ‘70s. Since 1980, however, we’ve been in a structural disinflation regime. Under Paul Volcker, chair of the Federal Reserve (Fed) for much of the 1980s, inflation was ultimately contained by his focus on the growth of the money supply rather than interest rates, and price levels remained low and stable until the Covid-era.

Since the third quarter of 2020, we have seen persistent upside surprises, but the shape of the next inflation regime is an open question. In our view, it entirely depends on what central banks do.

Is a recession inevitable?

If inflation doesn’t prove self-correcting, there is a straight choice between a deep recession and a once-in-a-generation inflation regime paradigm shift. Regarding the former, central banks can tighten policy for a sustained period and bring inflation back under control, thereby causing a recession.

For context, the post-War bout of inflation in the late 1940s offers some parallels with today’s environment. There was a sudden release of pent-up demand from consumers wanting to spend, there were supply-chain disruptions as the economy pivoted from a military footing, and there were widespread commodity shocks. The Fed – which had tripled the money supply from 1939-1946 to help fund the war effort – sought to shrink its balance sheet and slow the availability of credit. The result was that inflation sharply fell back from nearly 20% to a deflationary environment, and an 11-month recession ensued from late 1948.

The second option central banks have is to take policy tight but then quickly back off, due to weakness in growth, without fully getting inflation back under control. This is likely to be more painful in the long-run, increasing the likelihood of a period of stagflation, which historically leads to weakness in risk assets as the growth backdrop weakens, but – unlike in the recessionary scenario – bonds notably underperform, with real assets providing protection from inflation.

What are central banks actually doing?

Central banks have rightfully taken a bit of bad press in recent months. They were wrong about inflation because their own inflation models are designed to always forecast inflation returning to target, and therefore are unable to deal with shocks. Looking at inflation forecasts back in Q3 2020 for the US, Eurozone, Japan and China serve to highlight this point. They were wildly inaccurate, so much so a random number generator would have outperformed their forecasts. To be fair, private forecasts were not better.

We have also had several wide-ranging and interrelated series of economic shocks that have continued to broaden from goods into services, including the supply bottlenecks across all categories resulting from pandemic-induced cuts, and of course the war in Ukraine. This has left central banks behind the curve. But they are now acting as they need to, and financial conditions are tightening. Even when actual rates have not fully risen, the increased size of the financial sector relative to the overall economy and relatively high leverage mean, as Mary Daly of the San Francisco Fed pointed out earlier this year, “the long and variable lags [of policy] may not be as long, or variable, as typically assumed.”

This cycle of hikes is already one of the fastest in recent decades, with the Fed’s policy rate expected to approach 3.6% by the end of 2022. For now, the Fed is being very clear it does not want a shift to a higher inflation regime, and if this comes at the expense of growth and weaker asset prices then this is the price they are willing to pay.

Authored by

Alex Holroyd-Jones
Portfolio Manager
Alex is a portfolio manager in the Multi-Asset team at Ninety One. Alex’s research responsibilities include...
Jason Borbora-Sheen
Portfolio Manager
Jason is a portfolio manager in the Multi-Asset team at Ninety One. He is co-portfolio manager...

Important Information

The information may discuss general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. The economic and market views presented herein reflect Ninety One’s judgment as at the date shown and are subject to change without notice. There is no guarantee that views and opinions expressed will be correct and may not reflect those of Ninety One as a whole, different views may be expressed based on different investment objectives. Although we believe any information obtained from external sources to be reliable, we have not independently verified it, and we cannot guarantee its accuracy or completeness. Ninety One’s internal data may not be audited. Ninety One does not provide legal or tax advice. Prospective investors should consult their tax advisors before making tax-related investment decisions.

This communication is provided for general information only and is not an invitation to make an investment nor does it constitute an offer for sale. Investment involves risks. This is not a recommendation to buy, sell or hold a particular security. No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided. The securities or investment products mentioned in this document may not have been registered in any jurisdiction.

In Singapore, this communication is issued by Ninety One Singapore Pte Limited (company registration number: 201220398M) and has not been reviewed by the Monetary Authority of Singapore.

Except as otherwise authorised, this information may not be shown, copied, transmitted, or otherwise given to any third party without Ninety One’s prior written consent. © 2024 Ninety One. All rights reserved.

Past performance shown are not indicative of future performance. Investors are reminded that investment involves risk. Investors should read the prospectus and product highlights sheets of the funds which are available from or any of the appointed distributors before making any investment decision. Please contact your financial advisor if you are in doubt of any information contained in this website. The value of the shares in the fund and the income accruing to the units, if any, may fall or rise.

By clicking on the hyperlink of Investor relations below, you are leaving this website with information specific for retail investors in Singapore and entering the global website.

Please note that the global website is not intended to target investors in Singapore. It has not been reviewed by the Monetary Authority of Singapore (“MAS”). The website may contain information on funds and other investments products that are not authorised or recognised by the MAS and therefore are not available to retail investors in Singapore. The prospectus and any other document or material in connection with the offer or sale, or invitation for subscription or purchase, of the shares of these funds and/or other investment products may not be circulated or distributed, nor may such shares be offered or sold, or be made the subject of an invitation for subscription or purchase, whether directly or indirectly, to persons in Singapore. The website may also contain information on investment services / strategies that are purported to be carried out by an Ninety One group company outside of Singapore.

Any product documents and information contained in this website are for reference only and for those persons or entities in any jurisdictions or country where the information and use thereof is not contrary to local law or regulation.

This website has not been reviewed by the Monetary Authority of Singapore. Issued by Ninety One Singapore Pte Limited (Co. Reg. No. 201220398M).