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I read the following passage and the bolded section has me confused:

In theory, assets earn a low (or negative) risk premium if they tend to perform well when the economy is weak. When growth and inflation are primarily driven by aggregate demand, nominal bond returns tend to be negatively correlated with growth and a relatively low term premium is warranted. Conversely, when growth and inflation are primarily driven by aggregate supply, nominal bond returns tend to be positively correlated with growth, necessitating a higher term premium.

I thought that growth and nominal bond returns were usually negatively correlated. Why would the growth being supply or demand-driven affect this correlation?

Thank you for any and all answers!

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    $\begingroup$ Hi, could you please cite the title of the book? $\endgroup$ – Student Nov 21 at 18:06
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When growth and inflation are primarily driven by aggregate demand, nominal bond returns tend to be negatively correlated with growth

Actually, the above sentence is the explicited version of what you have in mind, i.e. the links between nominal (vs real) returns, (demand-driven) inflation and growth.

when growth and inflation are primarily driven by aggregate supply, nominal bond returns tend to be positively correlated with growth.

The point is that "supply-driven inflation" is the broad way of saying "weak or no inflation" or even "deflation" (avoided since politically undesirable). Put differently, when growth and inflation are primarily driven by aggregate supply, nominal bond returns tend to be ... real and thus to be positively correlated with growth. Indeed, the traditional (neoclassical) explanation is that non-weak real rates stimulate savings which in turn stimulates technical progress and ultimately, economic growth.


All that being said, the passage you quote is curiously phrased.. and the key words appear to be "tend to be".

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  • $\begingroup$ Any question @JrAnalyst ? $\endgroup$ – keepAlive Nov 20 at 20:58
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I think it will help to fill in some of the missing causal elements in this picture. Suppose a classical economy at equilibrium, and understanding "growth" as growth in nominal GDP,

When growth and inflation are primarily driven by aggregate demand...

All else equal, a positive demand shock (rightward shift) leads to higher consumption (growth) and higher prices (inflation). These together imply both higher nominal and real output.

So: when growth/inflation are driven by demand, they are positively correlated with demand. Loosely, this means that GDP and prices are moving in real, not just nominal terms and are a sign that the economy will do well in the future. Bond returns will drop (through some combination of higher prices and lower coupon rates), since they are positively correlated with risk of default (among other things) and that risk is falling, in the aggregate.

when growth and inflation are primarily driven by aggregate supply...

The opposite is true here. When supply drives growth, it does so by shrinking. A negative supply shock (leftward shift) reduces consumption (contraction) and raises prices (inflation). Real output falls, while nominal GDP may rise or fall depending on how high the induced inflation is.

So: when growth/inflation are driven by supply, they are negatively correlated with supply. Notice that it is no longer the case that GDP and prices move in real terms*. While it is mathematically feasible that real output falls but prices rise so high that nominal GDP rises, this is unlikely to happen in the absence of other indicators that show that the overall economic outlook is bad (e.g., high unemployment). Therefore this is a sign that the economy will not do well in the future. Bond returns will rise because they are positively correlated with risk, and in the aggregate, things are looking risky.

*What I mean by this is just that it's less clear that more nominal GDP == more real GDP; it could be that more nominal GDP == less real GDP.

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