Managing Inflation Risks: A Practical Guide

Inflation is a critical challenge that demands the attention of risk managers. It is a focal point for central bankers, businesses and households, and the impact inflation can have on businesses and lenders requires a vigilant and proactive approach to safeguard financial stability and foster sustainable growth.

As we witnessed in the aftermath of the pandemic, the relentless climb of prices doesn't merely create uncertainty; it stirs a profound anxiety across the economic landscape, compelling consumers and investors alike to hold back on spending and investment – actions that are vital for economic growth. For credit providers, this isn't a matter of casual observation but a pressing issue that directly affects the performance of their outstanding loans and future origination volumes.

What factors must lenders and their risk managers consider in their efforts to mitigate inflation risk, and what adjustments do they have to make to credit risk models? We’ll talk about all this in a minute, but the first step in this process is figuring out the best inflation assessment tool.

Cristian deRitis

A Question of Measurement

A major challenge for understanding and managing inflation risk is the ability to accurately measure it in real time. High inflation rates can significantly harm the economy, especially when future inflation expectations spiral out of control, causing both consumers and businesses to change their behaviors in ways that limit growth and lead to higher joblessness.

But determining what constitutes “too high” inflation, and whether increases in some individual prices are more critical than others, is complex.

Economists have wrestled with the question of how best to measure inflation since the beginning of human civilization. This has led to the development of a wide variety of inflation measurement methods that consider which goods and services to include, which weights to attach to each of these components, and which method should be selected to calculate price changes that best reflect consumers’ actual cost of living.

The Consumer Price Index (CPI) is widely used due to its straightforward approach and timely updates. The CPI calculates an inflation rate by taking a weighted average of the prices paid by consumers for a predetermined basket of goods and services.

To get a clearer picture of underlying inflation trends, the Core CPI excludes volatile food and energy prices. It’s not that food and energy prices don’t matter – they account for 20% of household budgets. However, given how much these prices can fluctuate from month to month, a headline CPI measure that includes them may deliver a false signal of underlying trend inflation.

Economists have also sought to refine this core measure even further by considering medians, trimmed means and other methods for limiting volatility. But while the CPI is popular, many economists, including those at the Federal Reserve, prefer the Personal Consumption Expenditures (PCE) index.

The PCE stands out from the CPI in two important ways: first, it accounts for prices paid by businesses on behalf of consumers, such as health insurance; and second, it adjusts the weights on individual components based on behavioral changes in response to price shifts.

For example, if the price of apples were to suddenly rise, consumers might buy fewer apples and more of a substitute, like oranges. The dynamic weighting in the PCE accounts for this substitution effect to provide a more accurate view of the prices actually paid by households.

As depicted in the chart above, both the CPI and PCE indices have shown similar trends of decline from their 2022 highs, with the annual growth rate of the PCE about a percentage point lower than the CPI due to substitution effects.

Despite this difference, both measures indicate that inflation is running above the Federal Reserve’s 2% target. Furthermore, the sharp improvements observed in the second half of 2022 have since petered out, with the risk that the Fed will need to hike interest rates even higher to weaken demand, risking a recession.

The chart also displays the “harmonized index of consumer prices” – an alternative measure for calculating inflation. The key difference between this measure and the others is that it excludes so-called “owners’ equivalent rent” (OER). This component attempts to capture changes in the cost of housing that homeowners’ implicitly pay themselves.

Statisticians attempt to estimate an imputed rent value by examining rental properties. However, given differences between rental and owner markets, this estimate is imperfect.

In fact, the potential for error in the OER estimates is so great that the UK, Germany, France and other eurozone countries exclude it from their harmonized inflation measures. Using a similar approach (one that omits OER), the U.S. inflation rate would have already fallen to the Federal Reserve’s 2% target.

Inflation and Borrower Behavior

In addition to driving monetary policy, the precise measurement of inflation has important implications for modeling consumer behavior. The current level of inflation can influence spending and saving decisions in the near term due to the impact that higher prices can have on balance sheets.

Households’ expectations for future inflation are even more important. If consumers believe that prices will grow at a more modest pace in the future, they may take price hikes in stride – especially if their incomes experienced a similar increase.

More insidious is the possibility that consumers don’t believe that price growth will moderate any time soon. Expectations for accelerated growth in prices can turn into a self-fulfilling prophecy as consumers pull back on their future spending. The resulting price instability can race ahead until the system ultimately crashes.

For households and businesses with outstanding loans, the impact of high inflation on payment performance depends on the structure of their debts. For fixed-rate loans, like the typical U.S. mortgage, inflation may reduce the risk of default. For example, if wages increase alongside prices, borrowers will find that they need to dedicate a smaller portion of their incomes towards repaying their loans, lowering the likelihood of delinquency.

However, inflation also has indirect effects that can strain a household's financial health. For instance, as the cost of essentials like food and utilities rise, consumers might struggle to meet all of their financial commitments, potentially leading them to default on some as they prioritize their spending.

Lenders need to be mindful of how inflation alters consumers' payment priorities. For example, the increasing cost of necessities – including homeowners insurance – could lead to higher defaults on unrelated debts like credit cards and personal loans. To adapt, lenders should refine their credit risk models to include updated measures of a borrower's financial capacity (or income after essential expenses) and be alert to changing spending priorities.

Lenders can further enhance their risk monitoring and loss mitigation strategies by integrating additional data sources. These could include updated information on borrowers' performance on other loans and changes in income or expenditure patterns. Such insights can help lenders identify signs of financial stress early and take steps to mitigate risk through enhanced servicing and credit line management.

Moreover, lenders need to consider inflation forecasts and expectations as they determine their loan origination strategies. As the adage goes, the most effective credit risk management occurs before loans are ever originated.

Parting Thoughts

U.S. inflation is set to decline as the supply side of the economy adjusts and consumer demand moderates. But the process will take time, given persistent increases in housing costs and other services such as medical care.

Longer term, aging demographics and technological advancements point to a downward trend. However, the costs of transitioning to a green economy and the movement toward deglobalization will work in the opposite direction, keeping inflation rates higher than they were prior to the COVID-19 pandemic.

Risk managers were able to largely ignore the effects of inflation over the last 30 years, because price growth was low and stable. But that is certainly no longer the case.

Considering our evolving economy and the inflationary threats posed by geopolitical risks, we need to think about the direct and indirect impacts that inflation can have on our business processes and balance sheets – and adjust our credit policies accordingly.

Cristian deRitis is the Deputy Chief Economist at Moody's Analytics. As the head of econometric model research and development, he specializes in the analysis of current and future economic conditions, scenario design, consumer credit markets and housing. In addition to his published research, Cristian is a co-host on the popular Inside Economics Podcast. He can be reached at cristian.deritis@moodys.com.