Inflation or Deflation: A framework to map the long run ...

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Inflation or Deflation: A framework to map the long run probabilities

September 2021

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Contents

Sree Kochugovindan

Senior Research Economist

Luke Bartholomew

Senior Monetary Economist

Jeremy Lawson

Chief Economist

Executive Summary 3

The case for economic paradigms 6

Alternative paradigms 10

Thinking through the changing US fiscal outlook through the paradigms process 12

Mapping the path to different paradigms 13

Conclusion 17

Authors

Executive Summary

As the world struggles with the impact of the Covid shock, there is much more uncertainty than usual about the long-term outlook for economic growth, inflation, interest rates and the returns on risk assets. For most of the last decade our long-term global forecasts have been dominated by expectations of sluggish growth, modest inflation and low interest rates.

We think that the Covid crisis has reinforced many of these same secular stagnation themes that have dominated the global economy since the financial crisis. In particular, we expect the large output gap – the amount by which economic output falls short of its potential – opened up by the crisis to weigh on inflation significantly. The combination of insufficiently stimulative policy responses and various structural changes will also leave the global economy permanently smaller than it would otherwise have been. As a result, the term structure of interest rates – the relationship between interest rates or bond yields and different terms or maturities – will remain considerably lower.

That said, there is certainly scope for inflation to fluctuate around this lower average level, as idiosyncratic factors around index composition, seasonal quirks, and various base effects have already pushed inflation temporarily higher. However, this move does not signal a transition to a higher inflation regime unless the fundamentals that determine underlying inflation also change.

In the context of much discussion of historically large government deficits and central bank balance sheets, and the risks to inflation these might pose, it may seem strange to speak of ‘insufficiently stimulative policy’. However, our view is that there is little in the current policy mix which suggests to us that we are heading towards much higher inflation over the longer term.

Our reading of economic history and theory suggests that there are three jointly necessary and sufficient conditions to move to persistently higher inflation: . The economy must be in a state of meaningful excess

demand; . Inflation expectations must be weakly anchored; . Central banks must cease to set policy in accordance

with the principle that real interest rates cannot be allowed to continue to decline.

It seems to us very unlikely that each of these conditions will be met, underwriting the conviction in our base case.

However, our base case is just one of many plausible long-term economic scenarios or paradigms, and asset markets must price the full distribution of potential outcomes, not just the base case. Indeed even if the base case remains unchanged, evolving probabilities of various tail risks can lead to significant movements in asset prices.

We have therefore attempted to characterise the entire long-term probability distribution through developing a series of six economic paradigms, of which our base case is just one. These paradigms define the economic and market regime in its totality, covering various different demand, supply and policy fundamentals. Each one represents a potential long-term manifestation of various forces and policy choices at work today in the global economy.

3Inflation or Deflation: A framework to map the long run probabilities

Executive Summary

Our paradigms are: . Back to the New Normal (our base case); . Deflationary Slump; . Lowflation Acquiescence; . Productivity Rebound; . Central Bank Rethink; . Full Fiscal Dominance.

To provide a transparent framework to understand the economic and causal logic on which our assessment of the probability of these paradigms is based, and to detail the signposts and triggers that would see us update our views, we have developed an interactive tool which maps out the path from the disequilibrium of today towards one of the six paradigms.

The tool is a simple two-period model. For a given backdrop for the supply side of the global economy,1 it traces out the impact of policy set during period one on the state of the economy at the beginning of period two. And then, conditional upon the state of the economy and previous policy choices, the impact of policy choices on period two determines which paradigm we end up in.

By assigning probabilities to each of the various branching points along the tree, we are able to find the probability of any particular branch. And by adding up the probabilities of all the individual paths that lead to a particular paradigm, we are able to find the total probability for each of these paradigms.

1 The ‘supply side’ refers to the productive capacity of the economy.

Very Tight

5%

Lowflation

13%

Policy Policy

Deflation

10%

Economic Outcome Economic Outcome

Tight

10%

New Normal

43%

Neutral

30%

Central Bank Re-think

22%

Tight

15%

Neutral

60%

Loose

50%

TFP Rebound

8%

Very loose

5%

Fiscal Dominance6%

Modest Excess Slack

10%

Full Employment

50%

Modest Excess Demand

20%

Large Excess Demand

20%

Period 1 Period 2

Neg

ativ

e Su

pply

50%

04 Inflation or Deflation: A framework to map the long run probabilities

The upshot of our analysis is that, around our base case, we have an even skew towards paradigms that lead to higher inflation and those that lead to lower inflation. However, while it is our belief that the base case has been reinforced by the pandemic, the various political, policy and economic instabilities that it has unleashed have also increased the tail risks of much higher and much lower inflation. Indeed, only around 35% of the total probability sits within our baseline paradigm and there are meaningful differences in how these probabilities vary across the world’s major economies.

The beauty of this tool is that it allows other users to flesh out their own views on different policy and economic variables within a causally internally consistent framework, and see how those different views lead to different paradigm probabilities. It will therefore provide us, and others, with analytical capacity crucial to determining the long-term return environment. We therefore look forward to sharing and discussing the tool and its implications with both internal and external stakeholders.


That is why we have developed a series of other potential long-run scenarios – paradigms – which, collectively, we think constitute a spanning set of the possible long-run economic ‘steady states’. These paradigms define the total economic and market regimes covering various different demand, supply, and policy fundamentals. Each one represents a potential long-run manifestation of various forces and policy choices at work today in the global economy.

In the next section, we outline our base case paradigm in more detail.

Understanding our base caseOur base case – the paradigm we assign the single greatest probability weight to – is ‘Back to the New Normal’. For the global economy as a whole we assign a 35% probability to this base case.

In this paradigm, many economies return to the pre-Covid environment. The pandemic is a permanent shock to the trend level of economic output, but otherwise the global economy returns broadly to its pre-shock state. Trend growth rates and the equilibrium interest rate3 look like the post-global financial crisis ‘new normal’ secular-stagnation environment, while average inflation outcomes are lower.

For example, in the US, real growth settles at a trend level of 1.8%, while Consumer Price Index (CPI) inflation settles at 2% by 2025. The CPI at 2% is probably slightly too low to be consistent with the Fed’s preferred inflation measure of core Personal Consumption Expenditure (PCE) reaching 2%, and almost certainly is not consistent with the rate of inflation required to see inflation average at 2%.

Underlying our conviction in this base case is a conceptual foundation drawn from the research literature on various inflationary episodes. Economic theory and history suggest that there are three conditions that must be met before an economy can shift towards a different inflation regime:

The case for economic paradigms

As the world struggles with the shock of the Coronavirus, there is much more uncertainty than usual over the long-term returns outlook. For most of the last decade our long-term forecasts have been dominated by a base case view of sluggish growth, low inflation, and permanently lower interest rates. We had assigned a very low probability to the opposing tail risks of rapidly rising inflation, or a deflationary slump. In this environment, our long-term return forecasts were driven by the base case view.

And indeed, the most likely outcome of the current crisis is that it reinforces many of the secular stagnation trends that were present pre-Covid. After all, there is little doubt that there is currently a large shortfall in aggregate demand across the global economy, as well as considerable spare capacity in most labour markets. And even with a comparatively flat Phillips Curve2 in most countries, that spare labour capacity is set to put downward pressure on labour cost growth and underlying inflation for years to come.

This is the outcome that is priced into assets for the foreseeable future. Market-implied inflation expectations for the second half of this decade in the United States are just 1.8%, 0.5bpts lower than would be consistent with the Federal Reserve’s (Fed) long-term inflation objectives.

The gap is even larger considering the Fed’s new commitment to allow inflation to modestly overshoot the target to make up for an extended period of below-target inflation. Meanwhile, these differences between current inflation targets and market-implied inflation expectations are even larger in Europe and Japan.

Given current market prices, the risk is obvious. If inflation was to spring back rapidly, significantly and persistently, a wholesale repricing of government bonds would ensue. And depending on the drivers of any change in inflation dynamics, the pricing of risk assets would need to adjust as well.

Moreover, asset markets do not simply price in a single baseline view, but the probability of all potential outcomes. So changes to the probability of ‘tail’ outcomes – in particular the probability of much higher or lower inflation – will significantly impact asset prices and the appropriate asset allocation, even if the base case remains broadly unchanged.

2 The Phillips curve is the relationship between unemployment and inflation. 3 The interest rate which is consistent with the economy at full-employment and inflation at target.


. The economy must be characterised by a period of sustained excess demand. This could come from a large negative supply-side shock, or a large positive-demand shock, but either way, the demand for goods and services must be consistently greater than the productive potential of the economy.

. Inflation expectations must become unanchored, so that economic agents do not look through shocks to inflation, but start to build permanently higher inflation into their price setting behaviour. This embeds a circle of rising prices.

. Central banks must cease to set policy in accordance with the Taylor principle, which requires that over the medium term the central bank raises nominal interest rates more than one-for-one in response to any increase in inflation. This ensures real rates do not decline in response to an increase in inflation, which would ease monetary conditions further, likely leading to even higher inflation. For this reason, the Taylor principle is the ultimate guarantor of price stability.

These necessary conditions are not independent. For example, a central bank that ceases to follow the Taylor principle may engineer a short-term boom in the

Long term inflation expectations remain well anchored

0

2

4

6

8

10

12

20202014200820021996199019841978

Next 5 Years Next year

Source: University of Michigan consumer sentiment survey, Haver. As at August 2021

economy leading to a period of excess demand, but may eventually lose credibility on its inflation target, resulting in higher inflation expectations.

A good illustration of how these conditions work together is the pick-up of inflation in the US in the 1970s.

First, the combination of the oil price shock, sluggish technological change, modest rates of globalisation, and sclerotic labour and product market regulations meant that supply-side growth was weak. This meant that even relatively modest levels of demand growth were sufficient to tip the economy into a situation of excess demand.

Second, the ‘Nixon shock’ (whereby the US left the post-WWII Bretton Woods system of fixed-exchange rates and a dollar backed by gold) meant the US currency lost the nominal anchor which had previously underwritten price stability and inflation expectations.

Third, the Fed and other policy makers were operating with a faulty understanding of the macro economy, acting as if there was a stable trade-off between inflation and employment that could be exploited. Therefore, they were not setting interest rates in accordance with the Taylor Principle.


-202468

1012141618

20202010200019901980

OECD headline inflation % year on year OECD core inflation % year on year

1970

Inflation expectations became unanchored through the 1960s before oil prices trigged a negative supply shock in the 70s

Central bank frameworks change: Volcker's tough medicine triggered two recessions in the early 80s, before inflation expectations and prices started to trend lower.

GFC triggered a disinflatinary shock, with persisitent slack. GCC will do the same in the near term

1970s: negative supply backdrop; + fiscal indiscipline + central banks that prioritised unemployment over inflation.

%

Three necessary conditions to shift towards a new inflation regime

Source: data by Haver, abrdn Jul 2021.

Thus with all three conditions met, the economy was ripe for an inflationary spike which was only eventually contained by very tight monetary policy from the Fed, under Chairman Paul Volcker, throughout the early 1980s.

It is important to note that growth in the money supply, or the size of government debt or deficits, or structural forces – globalisation, technological change, labour and product market regulations, or demographics – do not feature in our list of conditions. That is not because they do not influence consumer prices. They most certainly do. But they only matter for long-term inflation dynamics and regimes to the extent that they influence, or are influenced by, our three core criteria.

To see why, consider the case of Japan since 1990. The end of the economic, credit and financial boom, as well as deteriorating demographics, were headwinds to demand growth. But the key reason for Japan’s descent into deflation, and its subsequent struggles to escape it, primarily relate to policy choices.

The Bank of Japan kept monetary policy far too tight in the decade after the crisis. Japan’s over-levered banks were not recapitalised quickly enough, further reinforcing the demand shortfall. And despite steadily rising public debt, fiscal policy was not sufficiently focused on supporting growth once policy rates were at their effective lower boundary.

Despite the massive expansion of the Bank of Japan’s balance sheet since 2013 and large budget deficits, monetary and fiscal policy have not been jointly expansive enough, or reactive enough, to growth and inflation disappointments in recent years. As a result, they have generated only a modest increase in underlying inflation.

Indeed, anyone wanting to argue that the combination of rapid growth in central bank assets, large budget deficits and high public debt set the scene for much higher inflation, must confront the reality of Japan and ask what is fundamentally different in Europe, the US or other advanced economies.

The case for economic paradigms



Around our central base case, we have an even skew of paradigms that lead to higher inflation, and those leading to lower inflation.

Full Fiscal Dominance This is the paradigm that sees the three necessary and sufficient conditions for higher inflation fully realised.

In this case, the current crisis prompts a very fundamental alteration in the balance between monetary and fiscal policy, to the point where fiscal policy is the primary tool of macroeconomic management. Governments, not central banks, effectively set the price level.

Monetary policy becomes subservient to debt financing considerations – not consistent with price stability. In this way the Taylor rule is systematically violated. Inflation increases sharply, dragging inflation expectations up with it.

After an initial growth spurt, which leads to a period of excess demand, growth actually slows, as high and volatile price growth weighs on economic activity. This is why real growth in 2025 is only 1% in the US, with inflation at 6%. With the Taylor Principle violated, real interest rates are at -5.5% -- too accommodative to choke off the inflationary spiral.

We ascribe only an 8% probability to this paradigm occurring for the global economy, because we believe it is extremely unlikely that all three of the conditions will be met.

Crucially, this paradigm requires central banks, forced or otherwise, to continue to set very easy monetary policy, even after the economy has reached full-employment, in a manner which is completely inconsistent with their inflation objectives.

Central Bank Rethink This is a more moderate and less destabilising version of the above paradigm to which we assign a much higher probability: 18%.

Here, the crisis once again prompts a reassessment of the monetary framework with a move to a target that necessitates higher inflation, but the broader structure of stabilisation policy is still in place. In addition, a controlled reflation through discreet programs of co-ordinated fiscal and monetary stimulus, sometimes called ‘helicopter money’, would be deployed.

Alternative paradigms


Alternative paradigms

This leads to a long period of very supportive policy allowing the economy to recover and eventually run hot. As such, there is a period of excess demand which helps to push up inflation. This establishes the credibility of the higher inflation-targeting regime, helping to lift inflation expectations higher.

Critically, however, this move to higher inflation is still conducted under the auspices of a central bank committed to the long-run stability of prices, via setting policy in accordance with the Taylor principle.

As such, inflation and inflation expectations remain anchored. Growth (again using the US example) reaches 2.4% in 2025 due to easier policy, while CPI inflation is 3.3%, as it moves towards the new target-consistent level.

Stimulus continues to be provided to embed the new regime with nominal rates at 1%, well below the equilibrium rate of 3.5% (which is much higher given the higher growth and inflation outlook).

We find this paradigm much more plausible than ‘Full Fiscal Dominance’, and it is broadly in keeping with some of the policy moves we have seen from central banks, such as the Fed.

However, our assessment of the Fed’s policy review is that on the whole it is pretty timid, making only modest changes to its policy framework. Therefore, it is unlikely to shock inflation expectations much higher. That is why the probability on this paradigm is no higher than 20%.

Lowflation Acquiescence In this case, inflation continues to fall below levels seen in the base case, but given their policy conservatism, this is accepted by central banks rather than fought aggressively with easier monetary policy.

This is a reflection of the institutional conservatism of central banks which provides the rationale for our most likely disinflationary paradigm.

Here, the side effects of further stimulus, such as they apparently are, are judged to be in excess of the benefits, and so reflation is not pursued and thus policy becomes less reactive to negative economic and financial developments.

As a consequence, we settle into both a lower inflation and more volatile growth regime. For the US example, growth is 1.3% in 2025 and inflation 1.3%. Policy interest rates are at 1% in the US, above the equilibrium rate of 0.8%, as the Fed is no longer trying to stimulate the economy, having accepted the new low-growth and lower-inflation environment.

We give this paradigm an 18% probability, as it seems equally plausible to us that, in the face of persistently weak demand and the constraints of existing policy frameworks, central banks and governments come to accept that much lower inflation is here to stay, as it is that central banks move to target higher inflation. Indeed, in many respects, this seems to be the way policy makers in the Eurozone and Japan are already heading.

Deflationary Slump This is the most extreme disinflationary paradigm in which the crisis lowers trend growth, equilibrium interest rates, and inflation even further, effectively leading to ‘secular stagnation on steroids’.

Either because the virus becomes endemic and forms of social distancing permanently constrain economic activity, or behavioural changes at firms and households outlive the virus, the global economy is held back well into the future.

Central banks once again do little to combat this shock. Growth is a meagre 0.5% in 2025 while inflation is at 0%, reflecting the deep disinflationary trends, but also the difficulty of generating sustained deflation given various nominal rigidities such as the constraints around cutting cash wages. We give this paradigm a 15% probability.

Productivity Rebound There is one further paradigm that sees inflation slightly higher. However, the crucial drivers of ‘Productivity Rebound’ are not policy choices or demand shocks, but positive news on the supply side.

In particular, increased deployment and commercialisation of innovation pre-crisis, as well as the spurring of a new wave of innovation post-crisis, increase productivity growth and hence the trend growth rate of the economy. Equilibrium real interest rates rise.

Because this is a supply side-driven improvement, inflation pressures do not take off, although central banks are able to use the additional policy space opened up by a higher equilibrium rate to achieve their inflation targets.

In the US, the equilibrium policy rate increases to 3%, while the policy rate is just 2.5%. This stimulus, along with an improved supply side, pushes growth up to 3%, while inflation reaches 2.3%.

Given our somewhat pessimistic assessment of the future of globalisation, and the ways crises tend to both spur and harm innovation in quite subtle ways, we give this paradigm a relatively low 7% probability.


Thinking through the changing US fiscal outlook through the paradigms process

We can use our framework to understand the impact of further fiscal policy-loosening in the US on long-term inflation dynamics. This included a US$1.9 trillion stimulus package and plans for further spending on various infrastructure projects.

The main beneficiary of this move has been the ‘Back to the New Normal’ scenario, which incorporates inflation at, or slightly below, central bank targets.

The Fed has committed to a temporary overshoot in inflation to generate average inflation in line with its 2% target over the course of the business cycle. The stronger growth and inflation profile created by fiscal stimulus should make this easier to achieve, while making the low-inflation paradigms of ‘Deflationary Slump’ and ‘Lowflation Acquiescence’ less likely.

The change in the political environment also implies a slightly higher likelihood of a rethink at the Fed. US President Joe Biden will have the opportunity to reshape the leadership of the Federal Open Markets Committee in the early part of his term and he could push for more

progressive candidates, who might make more ambitious changes to the policy framework than that delivered under the current chairman, Jerome Powell.

However, we do not think that this should be interpreted as a slide towards ‘Full Fiscal Dominance’, in which the Fed’s independence is threatened and it is forced to accommodate persistently higher government spending.

As such, there is no greater risk of the Taylor principle being systematically violated in the future. Therefore, we do not think it signals a greater possibility of the very high inflation we would expect under ‘Full Fiscal Dominance’.

Finally, we also think that the likelihood of a productivity rebound has increased slightly. This reflects the benefit of strong short-term growth and higher public infrastructure spending, which could unlock a virtuous cycle of investment and innovation.

These changes do not significantly alter the big picture probabilities for the global economy, only for the US.

Updated to incorporate US policy changes End 2020 probabilities

0%

10%

20%

30%

40%

50%

Fiscal dominanceTFP reboundCentral bank rethinkNew normalLowflationDeflation

Updated US paradigm probabilities

Source: abrdn, March 2021.


Mapping the path to different paradigms

To demonstrate more clearly how we have derived these probabilities, and to provide a framework to reassess the probabilities as the economy evolves, we have built an interactive tool which maps out the many different paths by which the economy can travel to one of the six paradigms.

These paths involve multiple branching points, or nodes, depending on the state of the economy and the choices made by policy makers. By assigning probabilities to these nodes we can build from first principles the probability for each of the six paradigms occurring.

The tool is a simple two-period model. First, policy is chosen in period one, this leads to some economic state at the start of period two. Then policy is chosen again conditional on the state of the economy at the start of period two. This second policy choice causes the economy to develop into one of the six paradigms.

This structure embeds a number of economic assumptions reflecting our understanding of the inflationary process, and the relationship between policy and the economy more generally. The impact of current policy choices have lags, and there are feedback loops between the policy choice, the medium-term economic outlook and future policy choices.

By making transparent the causal and economic logic that underlies our analysis, we aim to provide a consistent framework and ‘language’ for others to engage with our analysis and to derive their own conclusions.

Paradigms and Probabilities

Paradigm Total probabilities

Deflation 15%

Lowflation 18%

New Normal 35%

Central Bank re-think 18%

TFP Rebound 7%

Fiscal dominance 7%

100%

Source: abrdn, March 2021.

Step-by-step guide on how the tool worksThis section provides a step-by-step guide to the tool, which should help to demonstrate more clearly how our own probabilities are derived and the questions we have wrestled with in forming our views. But it also explains to other users how they might also use the tool.

Step oneChoose a supply-side backdrop. There are two versions of this model, one under conditions of a positive net supply backdrop and another under conditions of a negative net supply backdrop. The user must assign a probability (expressed as a percentage) for each of these backdrops. Each supply backdrop has a slightly different set of paradigms associated with it, reflecting the different supply specifications for different paradigms.

In particular, we see four key aspects of the supply side as potentially impacting on inflation: . Technological change. Investment and innovation could

accelerate in response to dealing with the challenges of the Covid shock – pushing prices and wages lower, and boosting total factor productivity (TFP) growth.4 Alternatively the rate of innovation may remain broadly stable, which would be neutral on inflation, or even slow if we see tighter regulation and a tech cold war constraining collaboration and diffusion – putting upward pressure on inflation.

. Globalisation. We could see globalisation recover as US/China tensions soothe under a new administration and greater US emphasis on multilateralism. All else being equal, this would be disinflationary and positive for TFP growth. However, we might instead see on-shoring boosted and a rising current of populism that emphasises domestic production, which would tend to put upward pressure on prices and wages.

4 Total factor productivity is a measure of how effective the economy is at combining production inputs to generate new outputs


20

25

30

35

40

45

50

55

60

65

20182010200121994198619781970

World Trade (% of GDP) Correlation of cross-country wage growth steadily increased, %

0

10

20

30

40

50

60

2010-142003-071996-2000

Globalisation and its effects

Decades of globalisation may not be swift or easy to unwind Globalisation and technological progress combined to lower wage pressures globally

Source: World Bank, Haver, as at December 2019. Source: BIS, as at 2014.


. Demographics. The impact of demographics on inflation work through political, wage and consumption channels, which can push in several directions. An ageing population may push up wages if that means less labour supply, although presumably in equilibrium, wages are determined by productivity. Changing patterns of demand might see rising prices in some sectors – e.g. healthcare – and falling prices elsewhere, although these are perhaps best characterised as relative price changes and market signals rather than inflation per se. An older population may use its political power to, in effect, vote for lower-inflation policies to protect fixed-income payments.

. Regulatory changes. Deregulation tends to lift productivity growth, erode labour bargaining and firm pricing power, and therefore boost potential growth and act as an inflationary headwind. Alternatively, we may see an increase in regulation to protect ‘key workers’ and other precarious employment relations exposed by the Covid shock, and the promotion of national champions to produce apparently strategic goods and services. This would tend to push up prices and push down productivity and growth.

It is important to note that the supply-side backdrop chosen here characterises both periods one and two, so there is no scope for further exogenous supply shocks. That’s why the probability assignment must reflect how the user expects the supply environment to influence inflation on balance over the entire period.


Step two: Select a policy choice at the start of period one. We define five broad policy regimes, which are assumed to be exhaustive, so the probabilities attached to the policies must together add up to 100%. The policy choices are: . Policy very tight. Monetary and fiscal policy is such that

growth is pushed a long way below its potential, with significant downward pressure on inflation.

. Policy tight. Monetary and fiscal policy together deliver growth rates moderately below potential, with modest downward pressure on inflation.

. Policy neutral. The combination of monetary and fiscal policy is such that it has neither a net stimulatory or net contractionary effect on the economy. Were the economy in equilibrium (target-consistent employment and inflation) this would be consistent with keeping it there. If the economy were in a state of either excess or shortfall of demand, it remains there.

. Policy loose. The monetary and fiscal stances are jointly consistent with growth that is pushed moderately above its potential, with modest upward pressure on inflation.

. Policy very loose. Monetary and fiscal policy together tend to push growth a long way above its potential, with very significant upward pressure on inflation. This policy regime can also be interpreted to imply that central bank frameworks are radically altered through the persistent non-target-consistent monetary financing of deficits and the explicit loss of central bank independence.

Step three: characterise the economy at the start of period two, conditional on the policy choice in period one. Assign a probability of the economy being in one of the following five states after whatever policy is delivered in period one: . Large excess slack. Output gap significantly negative

and widens further; inflation below target; economic sentiment and inflation expectations deteriorate sharply. Triggered either from a loss of policy credibility, or as a result of an exogenous demand or supply shock worsening growth and inflation outlook shifting the economy from one paradigm to another.

. Modest excess slack. Output gap persistently mildly negative; inflation below target; and inflation expectations anchored.

. Full employment. Output gap closed within the specified time horizon; inflation expectations anchored; inflation close to central bank target.

. Modest excess demand. Output gap positive; inflation exceeds central bank target; inflation expectations adjust higher than target.

. Large excess demand. Positive output gap very wide and growing; inflation above central bank target and on a rising trajectory; inflation expectations adjust much higher than target.

Some economic states are foreclosed – automatically assigned a probability of zero reflecting our judgement on the functioning of the economy.

For example, it is impossible to be in a state of excess demand at the start of period two after tight policy has been chosen in period one.

Similarly, it is impossible to be in a state of large excess slack after very loose policy has been delivered in period one.



Step four: Characterise the policy choice at the start of period two, conditional on the policy choice in period one and the economic state that has been realised along this branch. There are other factors to consider in assigning probabilities to the various policy stances at this stage.

First, policy is likely to be responsive to the economic state so, for example, very loose policy may be less likely in states when the economy is close to full employment in period two, than in states where there is still economic drag.

Second, policy errors made in the first period – i.e. choices that see the economy entering into period two a long way from full-employment – could mean-revert, or they could compound.

For example, a central bank that made an ‘error’ in its policy choice in period one may choose policy in period two to try to correct this. Or it may have revealed something about its preferences/ability/constraints in making this ‘error’ such that it is likely to make it again.

Step five:Decide to which paradigm this set of outcomes and choices leads. Conditional on all choices and outcomes up to this point, we assign probabilities to a paradigm for this branch.

At this point along the tree there are likely to be only a few paradigms that are plausible, with many of them foreclosed and perhaps some inevitable. For example, in a branch conditioned on very tight policy in periods one and two, then deflation and disinflation are the only possible paradigms.

All others are ruled out by the conditioning assumptions that have got us to this point on the tree. Similar logic, albeit with different outcomes, will apply for the other branches.

By multiplying the probabilities at each decision point along a branch, we get the probability of that particular branch being taken. Many different branches will all lead to the same paradigm.

So we group each of the branches according to the paradigm to which they lead, sum together the probabilities of each of the individual branches within a paradigm group, and this gives us the total probability for each paradigm.

A worked exampleTo make the guide slightly more tangible, consider the following worked example of different probability assignments given at each of the different steps.

Step 1 - Supply backdrop: 60% chance of a net positive supply backdrop

Step 2 - Policy choice period one: 25% chance of tight policy

Step 3 - Conditional on tight policy, economic state in period two: 70% chance of large excess slack

Step 4 - Conditional on tight policy in period one, and large excess slack in period two, policy choice in period two: 40% chance of loose policy

Step 5 - Conditional on tight policy in period one, large excess slack in period two, loose policy in period two, chance of paradigm: 70% chance of ‘Deflationary Slump’

The probability of this whole branch occurring is 0.6%*0.25%*0.7%*0.4%*0.7% = 2.9%.

Therefore 2.9% is added to the ‘Deflationary Slump’ paradigm bucket with all the other paths that also lead to this paradigm.


Conclusion

Markets price in the full distribution of possible outcomes, not just a base case. That is why even though the pandemic has broadly reinforced our base case, and we are unconvinced by some arguments that are sometimes made about why a move towards much higher inflation is more than just a tail risk. We have tried to characterise the full probability distribution of economic outcomes through developing our paradigms.

The paradigms represent a fully specified set of economic and financial market variables which, together with a probability assignment, allow us to construct an expected value for different variables and a sense of the skew on these variables.

To help us assign these probabilities, and to provide a framework that identifies critical nodes and trigger points that would make us reassess these probabilities, we have developed a tool which maps out the many different paths to the paradigms.

This tool allows other users to input their own views on different economic and policy outcomes and so develop their own paradigm probabilities in an internally consistent manner. We hope this will generate more fruitful conversations about the return environment, and we look forward to sharing the tool with others internally and externally.


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Any data contained herein which is attributed to a third party (“Third Party Data”) is the property of (a) third party supplier(s) (the “Owner”) and is licensed for use by Standard Life Aberdeen**. Third Party Data may not be copied or distributed. Third Party Data is provided “as is” and is not warranted to be accurate, complete or timely. To the extent permitted by applicable law, none of the Owner, Standard Life Aberdeen** or any other third party (including any third party involved in providing and/or compiling Third Party Data) shall have any liability for Third Party Data or for any use made of Third Party Data. Neither the Owner nor any other third party sponsors, endorses or promotes the fund or product to which Third Party Data relates.

This content is available in the following countries/regions and issued by the respective abrdn group members detailed below. abrdn group comprises abrdn plc and its subsidiaries: (entities current as at 27 September 2021)

Europe, Middle East and AfricaUnited Kingdom (UK): Aberdeen Asset Managers Limited, registered in Scotland (SC108419) at 10 Queen’s Terrace, Aberdeen, AB10 1XL. Standard Life Investments Limited registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. Both companies are authorised and regulated in the UK by the Financial Conduct Authority. Austria, Belgium, Cyprus, Denmark, Finland, France, Germany, Gibraltar, Greece, Iceland, Ireland, Italy, Luxembourg, Netherlands, Norway, Portugal, Spain, and Sweden: Aberdeen Asset Managers Limited, registered in Scotland (SC108419) at 10 Queen’s Terrace, Aberdeen, AB10 1XL, and Standard Life Investments Limited registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK. Switzerland: Aberdeen Standard Investments (Switzerland) AG. Registered in Switzerland (CHE-114.943.983) at Schweizergasse 14, 8001 Zürich. Abu Dhabi Global Market (“ADGM”): Aberdeen Asset Middle East Limited, 6th floor, Al Khatem Tower, Abu Dhabi Global Market Square, Al Maryah Island, P.O. Box 764605, Abu Dhabi, United Arab Emirates. Regulated by the ADGM Financial Services Regulatory Authority. For Professional Clients and Market Counterparties only.

Asia-Pacific Australia and New Zealand: abrdn Australia Limited ABN 59 002 123 364, AFSL No. 240263. In New Zealand to wholesale investors only as defined in the Financial Markets Conduct Act 2013 (New Zealand). Hong Kong: abrdn Hong Kong Limited. This document has not been reviewed by the Securities and Futures Commission. Thailand: Aberdeen Asset Management (Thailand) Limited. Singapore: Aberdeen Standard Investments (Asia) Limited, Registration Number 199105448E.

Americas Brazil: abrdn is the marketing name in Brazil for Aberdeen do Brasil Gestão de Recursos Ltda. which is an entity duly registered with the Comissão de Valores Mobiliários (CVM) as an investment manager. Canada: Aberdeen Standard Investments (“ASI”) is the registered marketing name in Canada for the following entities, which now operate around the world under the abrdn brand: Aberdeen Standard Investments (Canada) Limited, Aberdeen Standard Investments Luxembourg S.A., Standard Life Investments Private Capital Ltd, SL Capital Partners LLP, Standard Life Investments Limited, Aberdeen Standard Alternative Funds Limited, and Aberdeen Capital Management LLC. Aberdeen Standard Investments (Canada) Limited, is registered as a Portfolio Manager and Exempt Market Dealer in all provinces and territories of Canada as well as an Investment Fund Manager in the provinces of Ontario, Quebec, and Newfoundland and Labrador. United States: abrdn is the marketing name for the following affiliated, registered investment advisers: Aberdeen Standard Investments Inc., Aberdeen Asset Managers Ltd., Aberdeen Standard Investments Australia Ltd., Aberdeen Standard Investments (Asia) Ltd., Aberdeen Capital Management LLC, Aberdeen Standard Investments ETFs Advisors LLC and Aberdeen Standard Alternative Funds Limited.

http://www.abrdn.com

Date post:	08-Jan-2022
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