Inflation Implications in Relation to the Business Cycle

Inflation means generally rising prices. Inflation typically accelerates late in the business cycle (near the peak).

Disinflation means a deceleration in the rate of inflation. Inflation typically decelerates as the economy approaches and enters recession.

Deflation means generally falling prices. Deflation is a severe threat to economic activity because it encourages defaults on debt obligations but with interest rates near zero, central banks have limited tools to combat the issue.

Inflation and the Business Cycle

The Business CycleInflationEconomic PolicyMarkets
Initial recoveryInitially declining inflationStimulativeShort-term rates low or declining
Long-term rates bottoming and bond prices peaking
Stock prices increasing
Early expansionLow inflation and good economic growthBecoming less stimulativeShort-term rates increasing
Long-term rates bottoming or increasing with bond prices beginning to decline
Stock prices increasing
Late expansionInflation rate increasingBecoming restrictiveShort-term and long-term rates increasing with bond prices declining
Stock prices peaking and volatile
SlowdownInflation continues to accelerateBecoming less restrictiveShort-term and long-term rates peaking and then declining with bond prices starting to increase
Stock prices declining
ContractionReal economic activity declining and inflation peakingEasingShort-term and long-term rates declining with bond prices increasing
Stock prices begin to increase later in the recession

Inflation Expectations and Asset Classes

Inflation within expectationsCash equivalents: Earn the real rate of interest
Bonds: Shorter-term yields more volatile than longer-term yields
Equity: No impact given predictable economic growth
Real estate: Neutral impact with typical rates of return
Inflation above or below expectationsCash equivalents: Positive (negative) impact with increasing (decreasing) yields
Bonds: Longer-term yields more volatile than shorter-term yields
Equity: Negative impact given the potential for central bank action or falling asset prices, though some companies may be able to pass rising costs on to customers
Real estate: Positive impact as real asset values increase with inflation
DeflationCash equivalents: Positive impact if nominal interest rates are bound by 0%
Bonds: Positive impact as fixed future cash flows have greater purchasing power (assuming no default on the bonds)
Equity: Negative impact as economic activity and business declines
Real estate: Negative impact as property values generally decline

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