July 19, 2023
A well-balanced approach to inflation monitoring and risk assessment is key for successful asset allocation strategies in the current economic landscape.
Both the United States and the European Union are experiencing a decrease in inflation rates due to the fading impact of supply chain disruptions, energy shocks, labor market tensions, and restrictive monetary policies. However, the current situation is still uncertain, and experts agree that inflation rates will continue to exceed targets throughout 2023. Given this backdrop, we are exploring reliable methods to monitor inflation in real-time, while also accounting for the uncertainty surrounding the prediction of the permanent component of inflation.
The Month-Over-Month (MoM) measure of the core Consumer Price Index (CPI) is a more precise way to identify and track inflationary trends in financial markets. It offers a shorter time frame, which means it can capture immediate changes in inflation. This allows market participants to respond quickly to temporary inflation shocks, allowing more informed investment decisions.
On the other hand, the core CPI Year-Over-Year (YoY) changes are commonly used to assess overall price changes. By comparing prices to the previous year, it captures the permanent component of inflation and provides a smoother measure.
While MoM inflation is more immediate and reflects current inflation, it can be more volatile and subject to noise. Predicting MoM inflation can be challenging compared to the relatively smoother and less volatile core CPI YoY measure.
The YoY inflation rate usually changes gradually over time. When inflation goes up, the YoY rate tends to catch up slowly with the MoM measure, suggesting a slower adjustment (see Figure 1a) . On the other hand, when inflation decreases, the MoM measure tends to decrease at a faster pace. In situations where inflation drops sharply, the YoY rate might actually surpass the MoM rate, showing a relative increase in the annual comparison despite the monthly decrease (see Figure 1b) .
When constructing an asset allocation strategy, it is important to consider not only expected inflation but also the uncertainty surrounding the prediction of the permanent component of inflation.
Predicting uncertainty or volatility associated with inflation allows for the assessment of unexpected inflation, which can significantly impact investment decisions. Incorporating probabilistic measures of uncertainty, such as standard deviation or confidence intervals, helps investors better understand potential risks and adjust their strategies to manage unexpected inflationary developments.
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