Inflation will follow regimes or cycles no different than business cycles; however, inflation cycles may not overlap or match with business cycle behavior. A good inflation paper by Kinlaw, Kritzman, Metcalfe, and Turkington, "The Determinants of Inflation" provides a useful framework for analysis of inflation regime. We will not cover their deeper inflation work using the Mahalanobis distance function which provides an attribution technique for explaining inflation regime, but we present their general framework for identifying inflation regimes.
The authors focus on inflation shifts which is the difference between current annualized inflation and 3-year annualized inflation. Regimes are based on the form of inflation shifts. Using a hidden Markov model, the authors find that there are four inflation regimes, steady, rising stable, rising volatile, and disinflation. Inflation has been steady or rising stable for most of the post-GFC period. The 1970's were characterized by rising and volatile inflation. The current environment is now rising and volatile. This is the first time we have seen this type of regime since the early 1980's.
The features of different regimes can be viewed through macro variables that fall into different categories: cost push, demand pull, inflation expectations, monetary policy, and fiscal policy. There is a clear difference in these variables based on the regime encountered. Similarly, the returns for asset classes are very different based on the inflation regime. Investors should think about the inflation regime and the associated returns for different asset classes.
Given these regime attributes, the authors can conduct attribution analysis from the core features on the different inflation regimes. Additionally, they are able to provide these attributes in almost real time. Their most recent version of the working paper finds that federal spending was the key driver of the rising and volatile inflation regime as of February 2022.
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