Inflation Dependence Structure in a post-COVID-19 World

Mahmoud Bekri

29 May, 2022

Introduction

Inflation may be defined as the decline of purchasing power of a determined currency over time. It also determines the erosion of living standards. Inflation may be measured by the Consumer Price Index (CPI), a quantitative estimate of the inflation that may be captured in the rise of an average price level of a basket of determined goods and services, which are typically purchased by specific groups of households in an economy over a specific period.

We use the inflation data provided by OECD, measured in terms of the monthly growth rate, where the CPI index is estimated as a series of summary measures of the period-to-period proportional change in the prices of a fixed set of consumer goods and services of constant quantity and characteristics, acquired, used or paid for by the reference population.

Dependence Structure

We propose to investigate the dependence structure of inflation using two statistical measures: correlation and copula.

Correlation

Correlation is a dispersion measure that measures the degree to which two variables move in relation to each other, showing the strength of a relationship between both variables. It is expressed numerically by the correlation coefficient, which values range between -1.0 and 1.0.

A correlation coefficient of exactly 1 means that the correlation is perfect positive. It implies that as one variable moves, the other variable moves in lockstep, in the same direction and vis versa. A null correlation implies no linear relationship at all.

Copula

“Copula” is a Latin word, which means a “link” or “bond”, according to Patton (2004). It was conceived by Sklar (1959), who pioneered in demonstrating that marginal distributions may together (coupled) build a multivariate distribution.

Among the pros of the employment of copula are the dependency medialization that may be general, whereas correlation may model only the linear dependence. We use t copula because it shows better performance compared to the Gauss copula (Breymann et al. 2003).

Analyzed Countries

 We propose to give a look into the dependence structure of inflation in the following economic groups:

G7 Group

The Group of Seven (G-7) is an intergovernmental organization formed by the world’s largest developed economies, namely France, Germany, Italy, Japan, the United States, the United Kingdom, and Canada. The correlation coefficients results are given below:

BRICS Group

BRICS is an acronym for Brazil, Russia, India, China, and South Africa, that is coined by Goldman Sachs.

The term BRIC (without South Africa) in 2001, stands for the four BRIC economies that would come to dominate the global economy by 2050. South Africa was added to the list in 2010. The correlation coefficients are given below:

Three IsDB Member Countries

Three member countries of the Islamic Development Bank (IsDB) are members of the G20: Saudi Arabia, Turkey, and Indonesia, which is presiding over the G-20 this year. The G20 is a group formed by 19 of the world’s largest economies along with the European Union, representing more than 80% of the gross world product (GWP), 75% of world trade, and 60% of the world population. The correlation coefficients are given below:

Dependence of MCs with G7 and BRICS group

Interdependence between MCs

The dependence structure of the inflation rates is getting consistently stronger for G-7 group countries. Whereas the dependence structure for the BRICS group as well as for Turkey, Indonesia, and Saudi Arabia from one side and G7 and BRICS from the other side shows  the clear changes after the pandemic in comparison to before the pandemic: Several negative values of correlation change its sign, whereas only few vice versa and many small values of correlation turned to be high. This also holds true for the interdependence between Saudi Arabia, Turkey, and Indonesia.

Most of the results showed that inflation is getting higher dependent among the several countries. This implies a riskier economic environment, particularly for large financial institutions and global investors that require to undertake the heavy task of calibrating their investment portfolios to address this risk according.

Only a few negative values for the correlation were registered, which implies only rare opportunities of hedging that is becoming a much trickier task.

The graphs also point out that post-COVID-19, the inflation relation structure has become negative between Turkey and Saudi Arabia. That is, more often a rise in inflation in one country is accompanied by a decrease in inflation in the other country. The ame is the case between Indonesia and Saudi Arabia. However, between Turkey and Indonesia the inflation relationship is random. This may be due to different dynamics of Saudi Arabian economy and the pegging of SAR with USD. This also points to hedging opportunities.

The change in the inflation dependence structure needs to be taken seriously into consideration, particularly by risk and portfolio managers. Inflation is not only getting higher in a post-COVID-19 world but also turning to be much more complicated to be analyzed, as it is highly affecting all countries at the same time with different degrees.

The way to deal with Inflation

Several investors believe gold can be an excellent hedge against inflation, as it holds its value, while currencies decrease in value. However, stocks have proven to be a better hedge against inflation over the long haul.

As the increase in stock prices is inclusive of the effects of inflation, stocks constitute the best hedge against inflation.

This is due, inter alia, to the money supply additions that happen via virtual bank credit injections through the financial system, which has an instant effect on financial asset prices, such as stocks.

Furthermore, other financial products such as Treasury Inflation-Protected Securities (TIPS) are already employed to protect investments against inflation, as they are indexed to inflation, where the principal amount invested is raised by the percentage of inflation. Islamic alternative financial products such as Inflation-linked Sukuk or GDP-linked Sukuk may play a similar role in the Islamic finance industry.

It is high time for these financial products, already present in minor issuances in the capital markets, to take off.