Short-term Reflation Cycles
The laws of gravity don’t necessarily apply to consumer prices. What goes up does not necessarily come down. In modern times the trend is generally up. That’s why we call it inflation. Often the media says misleading things like “Inflation is coming down” when it goes from 4% to 3% and acts like prices are going back to where they came from. But inflation “coming down” is an oxymoron. What it means is that prices are rising less fast not returning to where they started. It’s kind of like using the gas pedal on a car. If your car is in drive and your foot is on the pedal, you’re always going forward. You can accelerate, or go forward faster. Or you can travel at a constant speed if you keep your foot on the same place. Or you can decelerate, or ease your foot off the gas so you’re accelerating less fast. But you’re still going forward unless you put the car in reverse. But even in reverse we can accelerate or decelerate.
Inflation means the economy is in drive mode. Inflation means prices are going up. It can go up faster, which we call reflation. Or it can stay constant which we call stable inflation. Or prices can be rising slower, which is called disinflation. But with inflation prices are always rising. Falling prices would be deflation, which is reverse for the economy. The reflation cycle, the speeding up and slowing down of inflation, occurs no matter what the level of inflation. But the reflation cycle has a different impact both through the level of inflation (the “Inflation Regime”) and/or the Market Uncertainty State. The graph below from the St. Louis Fed shows “sticky” CPI from 1987. Sticky CPI is a better indicator of the trend in inflation than headline CPI. We can see the waves of rising and falling inflation rates which illustrate the reflation cycle.
The relation/disinflation cycle is largely tied to the business cycle and central bank policy and lasts about 2 years, making it the shortest of the cycles and regimes I’ve studied. Because the reflation cycle is short, it’s really more about expectations than realized inflation. Where do investors and economic players think prices are going?
The cause of the reflation cycle is typically a classic supply/demand imbalance. As the economy grows demand for goods and services begins to outstrip supply causing reflation. Disinflation can have many causes. In the classic Keynesian cycle makers of goods increase production to meet anticipated growing demand, but overshoot and create too many goods. This over supply causes a drop in some prices and a slowdown in economic growth. Disinflation can also be caused by central banks who begin to tighten monetary policy as inflation begins accelerating and so reduce demand with higher interest rates.
The Short-Term Reflation Cycle Indicator (RCI)
I specifically label the RCI as short-term to further distinguish it from the Inflation Level Regime Indicator which we’ll discuss next.
The RCI uses three measures of inflation expectations and one measure from commodities. The expectation numbers come from a consumer survey, a forecasters survey, and the implied inflation forecast from inflation linked bonds. The combination of direct surveys and market implied numbers give us an idea of which direction the “market” thinks prices are moving. The commodity measure is the cost of materials for manufacturing which is also a survey of businesses but does not give an explicit inflation forecast. The indicator looks at the trend of these factors from their recent trend and uses a consensus to determine whether we are in a reflationary or disinflationary state. For the RCI there are only two states: Reflation and Disinflation.
Integrating with the other Indicators
But the impact the reflation cycle depends upon where we are in the Market Uncertainty cycle. Reflation is positive for stocks in the resilient market state. A little inflation is a sign of moderate growth and improving profits. But it’s not as positive for bonds where inflation erodes the real value of income. But reflation can be quite negative when the market uncertainty state is turbulent or fragile. Typically in those states the central bank has been raising interest rates for a while to slow the economy. Profit growth slows accordingly as demand falls. What stocks want, at this point, is a reduction in interest rates which can only happen if we have disinflation. Reflation means the central bank will continue to either raise rates or hold them at a high level. Neither is good. So counter-intuitively, reflation is bad for stocks and good for bonds if we’re in the turbulent or fragile market states.
Finally there is the relationship to the level of inflation. In “The Multiple Personalities of Inflation: History” (available by subscription) I show by using the momentum of CPI how assets behave when we’re in different types of inflation regimes. Supply driven, demand driven, and monetary inflation all affect assets differently especially during the reflation/disinflation cycle. The same is true for the levels of inflation as well which I will illustrate in future papers.
RCI does not use CPI momentum to measure the reflation/deflation cycle since momentum is backwards looking. Instead RCI contains measures of inflation expectations that are from surveys or market implied.
Conclusion
But as we see, inflation is always about prices rising. Reflation/disinflation is whether that rate is accelerating or decelerating. We haven’t spoken about when prices go down and the dreaded deflation. But in either direction, we’re still pressing down on the gas with varying amounts of pressure. This indicator estimates how much pressure the economy is exerting on prices.
