Intro: In the short term the demand for money tends to be the major driver of inflation. In the case of developed markets, improvements in economic confidence as shown by rising stock prices tends to correlate with higher inflation as the demand to hoard cash declines. In contrast, in emerging markets improvements in economic confidence lead to lower inflation as the demand for local currency increases.
As explained previously, inflation is driven by three main components: money (and government bond) supply, goods/services supply, and money demand, which itself is dependent on a number of other factors. In the near term, the demand for money tends to dominate the other factors and is the main driver of inflation changes around the economic cycle.
The following chart shows the correlation between equity prices relative to their trend and breakeven inflation expectations – market implied inflation expectations over the next decade. Correlation does not mean causation and it could reflect the impact of rising inflation expectations on equity prices. However, it seems more likely that both inflation expectations and equity prices are being driven by changes in confidence about the economic outlook. Despite the fact that strong growth is a deflationary force over the long term, improving economic confidence creates a willingness on the behalf of individuals to reduce their precautionary cash hoarding, raising inflation expectations.
Interestingly, the case in emerging markets differs substantially. The following chart shows the close correlation between Brazilian stock market performance and inflation expectations. In contrast to the US, improvements in economic confidence, as evidenced by the rise in stock prices, correlate with falling inflation expectations. The same holds true for Turkey, Mexico, and South Africa, the other emerging market economies which have breakeven inflation expectations data.
The implication is that improvements in economic confidence increases the demand for local currency in emerging markets, putting downward pressure on inflation expectations. While inflation expectations themselves are not great at predicting actual inflation, they are at least an unbiassed estimate of it and tend to be correct from a directional perspective.
Over the longer term, more fundamental factors tend to dominate behavioural factors. While money demand tends to be consistently lower in emerging market economies relative to their developed counterparts, changes in inflation rates are nonetheless determined by changes in money and government bond supply growth relative to the growth in supply of real goods and services in the economy.