Inflation and Default Dynamics

By Jain, Parul; Kamp, Leo | Business Economics, July 2010 | Go to article overview

Inflation and Default Dynamics


Jain, Parul, Kamp, Leo, Business Economics


Changes in inflation, particularly if they are sharp, can have important consequences for nominal contracts, especially debt instruments such as fixed-rate bonds. This paper examines the intricate dynamics of inflation and defaults. The experience of the United States during the past four decades is subjected to empirical analysis to examine how the nature of the relationship changed as we shifted from a high inflation to a low inflation regime. The paper is organized as a three-part study. We initially examine the U.S. default experience, as summarized in Moody's speculative grade default rate, along with industry differences. The paper then scrutinizes U.S. inflation dynamics as seen in different summary measures of the general price level and delves into pricing power issues. The study proceeds to examine co-movements in the inflation and default series from a theoretical and empirical standpoint and the results confirm the intuitive postulate: higher the inflation rate, the more pricing power companies have; greater pricing power leads to, better earnings and repayment abilities for firms and a lower incidence of defaults.

Business Economics (2010) 45, 174-186.

Keywords: inflation, default, leverage

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The modeling of business sector defaults, bankruptcies, and delinquencies has spawned a considerable literature, but there are few specific references made to the inflation backdrop in such analysis. Intuitively, a sharp change in inflation has important consequences for nominal contracts, especially debt instruments. A firm could undertake capital investment and borrow with the expectation that operating cash flows will suffice to service any debt incurred. However, such expected cash flows depend upon the expected future pricing environment. If actual price behavior falls below expectations, firms may be unable to service their debt, especially for those who have taken on large obligations (such as telecom companies in the late 1990s). Lower-than-expected cash flows also make it difficult to service debt through asset sales. Thus, dramatically lower inflation can trigger higher debt defaults. The point regarding stress from inherited financial contracts has been made in several earlier studies [Minsky 1982, 1986, 1992; Milesi-Ferretti 1995; Chiodo and Owyang 2003]. Regarding debt, Chiodo and Owyang [2003] make the point that:

  Unanticipated disinflation is costly to bearers of long-term debt
  who, when borrowing, forecast higher inflation rates. These costs are
  incurred because disinflation increases the value of the dollars that
  borrowers must pay back relative to what borrowers had expected.

Although the inflation and default rate connection is subject to several qualifiers, the data are throwing up another anomaly. Looking at Moody's speculative grade default rate since the 1970s, we are struck with a peculiar feature: through the 1980s, a falling default rate is associated with rising inflation; but around 1990, the relationship changes. Between 1990 and 1999, default and inflation rates moved in tandem. However, the pre-1990 inverse relationship reasserts itself with even greater force around 2000. Could this be a mere statistical anomaly or a more fundamental shift in the overall relationship?

The paper commences with a review of the discussion of the neglected inflation and default relationship and then examines the empirical evidence, with focus on the circumstances under which a direct or inverse relationship has arisen. Using Moody's default data, the empirical nature of the inflation-default relationship is also investigated in terms of causality and in the context of a Vector Auto Regressive (VAR) model. Although we note that different inflation measures can often give divergent signals, the major focus is on the Consumer Price Index (CPI) and its subcomponents.

The conjecture is that under certain ceteris paribus conditions, a stable inflation regime may be more important than high or low inflation in reducing the incidence of defaults. …

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