August 2023 / MULTI-ASSET
Inflation Globalisation
Understanding the drivers of domestic and global inflation
Key Insights
- Pandemic-induced high inflation exacerbated the 30-year-long phenomenon of increasing synchronisation, challenging consumers and investors alike.
- Economy-specific idiosyncrasies will both herald the end of high inflation synchronisation and result in novel tactical investment opportunities.
- Inflation trends tend to be shared globally over the long term, and global inflation‑sensitive strategies can be used regardless of investor location.
Understanding the drivers of domestic and global inflation is paramount for an investor to be successful in the current environment. Over the past several decades, inflation correlations across the globe increased as globalisation expanded its reach. In recent years, the correlation between US inflation and global inflation reached historically extreme levels after the Covid shock. In the short term, however, we expect inflation dynamics to differ, offering tactical opportunities to distinguish regional exposures. In this paper, we investigate different ways of quantifying the synchronisation trends of global inflation, offer some potential reasons behind why these trends have emerged, and discuss investment opportunities in the face of elevated inflation levels.
Is Inflation Synchronisation an Increasing Trend or Part of the Cycle?
We begin our investigation into global inflation synchronisation by quantitatively examining common inflation drivers and trends across countries.
The common drivers of global inflation have followed a cyclical pattern (Figure 1).1 We focus on a five decade sample of consumer price index (CPI) inflation rates for the United States, the United Kingdom, Australia, Canada, Germany, and Japan (G-6), which altogether account for 71% of the advanced economies’ gross domestic product (GDP) and 41% of global GDP.2 Significant moves higher in the explanatory power of the first principal component follow large common inflation shocks in the 1970s (commodities) and in the 2020s (pandemic-related supply chain disruptions and the expansionary policy response). On average, the common inflation factor produced using principal component analysis (PCA) explains nearly 60% of the variance in G-6 inflation. When large-scale common inflation shocks have occurred in the past, this proportion has reached almost 80%.
Common Component of Global Inflation in G-6 Economies
(Fig. 1) First principal component from G-6 CPI inflation
Note: Using year-on-year percentage change in headline inflation from the G-6 from December 1965 to January 2023, we calculate the proportion of variance explained by the first principal component in a 10-year rolling window over all countries available for an entire 10-year time horizon. Shaded areas are NBER recessions.
Sources: CPI inflation from U.S. Bureau of Labor Statistics, Statistics Canada, Statistisches Bundesamt, UK Office for National Statistics, Australian Bureau of Statistics, Japan Statistics Bureau, Haver Analytics; analysis by T. Rowe Price.
A similar cyclical pattern is evident when looking at the correlation of US inflation and other developed economies’ inflation. The five-year average rolling correlation of US CPI inflation with that of the UK, Australia, Canada, Germany, and Japan oscillated and substantially increased in response to common shocks. However, greater harmony in global inflation is more than just a product of commodity shocks.3 Since the mid-1990s, the trend in the five‑year rolling average correlation of CPI inflation in global economies to the US has steadily increased (Figure 2).
Consumer Price Index Inflation Correlations
(Fig. 2) 5-year rolling average correlation of CPI inflation
As of March 2023.
Source: Haver Analytics. CPI year-on-year percentage change; WTI Cushing (average, in U.S. dollars per barrel) year-on-year percentage change. Oil shock included if year-on-year change was greater than 30%.
Correlation of U.S. CPI inflation with that of the UK, Australia, Canada, Germany, and Japan.
Graph shows average over countries. Analysis by T. Rowe Price.
We found a more pronounced inflation synchronisation trend, starting in the 1990s, when using a broader inflation metric.4 In this case, the inflation factor not only includes a consumer price inflation gauge, but also one for producer price inflation, trade costs or unit value indices, plus inflation sentiment and expectations. Our analysis indicates, similar to the one with CPI inflation, that there has been a marked and steep increase in global inflation synchronisation since the 1990s. The unique post-pandemic global environment and policy responses have added to the heightened synchronisation as the correlation is currently at historical highs (Figure 3).
Correlations Based on a Broader Inflation Factor
(Fig. 3) 5-year rolling average correlations of inflation factors
As of April 2023.
Five-year rolling average of rolling correlations of inflation factors for the U.S., UK, Australia, Canada, Germany, and Japan. Inflation factors are machine-learning estimates of the common driver of inflation, expressed as deviations from its 10-year mean.
Source: DeepMacro, LLC; analysis by T. Rowe Price.
The sustained synchronisation in inflation trends among developed markets is likely attributable to globalisation and the interconnectedness of economies through trade, global supply chain integration, and international capital mobility, as well as economic policy convergence (please refer to “Drivers of Inflation Convergence”).
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Thomas Poullaouec is head of Multi-Asset Solutions, Asia Pacific. Prior to joining T. Rowe Price in 2017 he was managing director and regional head of strategy and research in the Investment Solutions Group for State Street Global Advisors in Hong Kong.