From inflation to deflation

A market wisdom says that high oil prices are the best medicine against high oil prices. After all, expensive input factors, such as high energy costs, slow down economic momentum and thus reduce demand. According to economic theory, lower demand in turn leads to a falling oil price. The question now is whether this pattern will also play out with the current record-high inflation. In the coming year, the inflation rate will tend to fall year-on-year because of the base effect, but the development of inflation and its drivers is much more complex.

High price pressure leads to deflation

In the past decades we have repeatedly experienced phases marked by rapid price growth. Table 1 shows the years in which high inflation rates were recorded in the US, looking at the last hundred years. In addition, all recessions in the United States are listed.

At first glance, two points are noteworthy: an annual inflation rate above 3% has led to a recession every time, but not every recession has been triggered by high inflation.

On closer analysis, we find that high price pressure has always led to deflationary tendencies or even deflation. Before a recession, inflation peaked at an average of 6.9%, and after a downturn, inflation fell to a low of 0.1% on average. The historical development could lead to the assumption that after the aggressive rate hikes, central banks merely have to wait until inflation starts to fall again. But unfortunately this is not the case. As the past also shows, the time it took for inflation to reach the central bank target again varies enormously. In the US, it took on average 16.2 months for inflation to fall below the Fed target of 2%, but the individual time spans range from half a year (2008: 5 months) to over three years (1981: 41 months).

Moreover, the question arises as to how much today's situation is at all comparable with the seventies, for example. However, what is true today, as it was in the past, is that there is a time lag between the central banks' interest rate hikes and the effect on the economies. Thus, the Federal Reserve's multiple rate hikes of 75 basis points are not likely to have an impact on economic momentum until the first and second quarters of 2023.

Short-term bonds are attractive

Two- to three-year inflation expectations in the US are already below 3%. The current situation is therefore unlikely to be an outlier by historical standards. Besides two- and three-year US government bonds, which currently yield 4.5% and more, short term corporate bonds with high ratings (“A”) are attractive again. The yield to maturity in the US dollar space is around 6%, in the Eurozone around 4%.