The outlook for inflation is one of our favourite topics on Think Big (here’s why), and this week we highlight some useful research from the Bank of International Settlements (BIS).

Known as the ‘bank for central banks’, the BIS provides banking and research services and helps the world’s central banks foster monetary and financial stability in the global economy.

The central takeaway from its inflation modelling was that for advanced economies such as the US and Australia, “deflationary risks are dominant”, whereas for emerging economies the inflation risk skews to the upside.


Getting the policy mix right

Already, COVID-19 has posed an historic challenge for policy makers working at central banks and major governments.

The extreme measures – interest rate cuts and bond market intervention from central banks, and record fiscal spending from governments – have so far helped keep the economy afloat.

Looking ahead, the BIS analysts highlight that “monitoring inflation risks and understanding what factors drive them is particularly relevant in calibrating the appropriate policy response”.

The analysts (Ryan Banerjee, Aaron Mehrotra and Fabrizio Zampolli) said that while most central banks gauge the direction of inflation using scenario analysis, that can also be complemented by an inflation-risk framework.


Inflation framework

The framework they set out assesses the direction of inflation 12 months ahead, based on the current level of GDP growth and inflation combined with oil prices and the moves in a given country’s exchange rate.

The model covers 43 economies across the globe, 12 of which it defined as “advanced” and 31 which were “emerging”.

They also adjust the model for levels of stock market volatility, to “investigate the effect of financial conditions and the broader effect of uncertainty”.

Playing devil’s advocate with their own data, the analysts cited two uncertainties in the model; 1. the effect of unusual changes in consumption patterns caused by enforced lockdowns, and 2. the potential impact of huge fiscal spending measures.

So how do inflation risks look once all those variables have been crunched together? It depends where you look.


Advanced Economies vs Emerging Markets

For starters, the broader collapse in GDP growth “has, on balance, increased downside inflation risks” in advanced economies, the BIS analysts said.

“Such effect is consistent with firms keeping their prices rigid in ‘normal times’ but applying steep discounts when firm demand is sufficiently low.”

(The BIS team did concede that while economic growth has fallen off a cliff in the June quarter, it may also bounce back faster towards the end of the year).

However, for emerging economies, the data indicates that “as growth slows, upside inflation risks rise”.

“This could reflect changes in external financing conditions, changes in the terms of trade, or supply factors,” the analysts said.

In addition, they said the exchange rate factor – emerging market currencies typically depreciate in an economic crisis – also gives rise to upside inflation risks.

“For a similarly sized movement in the exchange rate, the impact on median inflation is estimated to be around six times larger in emerging markets than advanced economies,” they said.

In a nutshell, the analysts concluded that “the output collapse due to the COVID crisis is associated mainly with greater downside risks to inflation in the near term”.

And shortly after the release of their report, US GDP posted its largest decline in annualised terms since record-keeping began.

So if the data modelling proves accurate, Australian stock investors don’t have to factor in the inflation risk just yet. But it always pays to keep an eye out for evidence of whether long dormant inflationary forces are starting to stir.