Reflation: Definition And How It Works

Reflation: Definition And How It Works
Reflation: Definition And How It Works

Reflation is characterized by both a sharp rise in the prices of consumer goods and an increase in the wages that pay them.  The economic life cycle that begins with reflation usually follows a certain pattern. 

First, when more jobs become available, employers must compete for the best candidates, so they begin to increase compensation packages.  Higher wages mean that companies have to raise the prices of the goods or services they produce. 

Higher prices mean that the next phase has begun: inflation.  When inflation rises, the Federal Reserve usually steps in and raises interest rates, as it did most recently in March.  Rising interest rates make it more expensive to borrow, which slows growth and the rate of price increases.

What Is Reflation?

Reflation is inflation that usually occurs immediately after a low point in an economic cycle—often after economic stimulus—and reflation trading is the buying of certain stocks or sectors that are believed to outperform in this type of environment.

Reflation can reflect monetary policy aimed at stimulating spending and stopping deflation.

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How Does It Occur?

Reflation is the process of returning inflation to its long-term historical average and can be considered a cure for potential deflation. 

It is an attempt to reduce the natural economic contraction – or restart the cycle of business expansion – that invariably follows a significant expansion.

This can be done through monetary policy – ​​central banks can increase the money supply, lower interest rates and/or relax bank reserve requirements – or changes in federal fiscal policy that lower taxes or loosen business regulations. 

All of these efforts are being made to increase the amount of money flowing through the economy and to instill confidence in consumers and market participants.

What is the difference between Reflation vs Inflation?

Although both are characterized by rising prices, inflation and inflation are not the same thing.  Reflation is the recovery of prices lost during an economic downturn along with employment growth, and many economists see reflation as a healthy sign of an improving economy.  This is often accompanied by an economic stimulus.

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What Is Reflation Trade?

Reflation trade refers to an investment allocation approach that seeks to take advantage of an economy’s successful exit from a recession or period of slower growth more generally. 

This approach typically favors selling Treasuries and buying stocks that perform well at the start of economic growth.

How Does Reflation Trade Work?

Reflation does not simply mean that the market as a whole will rise when economic activity returns to a normal or even higher level.  Instead, the focus is on certain sectors that are rebounding after a downturn.

For example, some investors see reflationary dynamics in sectors such as hospitality or restaurants, which have been hit hard by the pandemic, along with travel and tourism, and more indirectly affected sectors such as energy and materials.

Part of the reflationary trade may be a shift from buying goods to services as people go out more often, whether to movie theaters, restaurants, theme parks and hotels.  These are the sectors that would do well if the reflation thesis turns out to be true.

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What Are The Pros Of Reflation?

  • Reflation increases the money supply in the economy and leads to economic growth in output.
  • Reflation also helps the economy to stabilize itself after severe deflation.
  • It also helps create jobs in the economy through increased consumption.
  • It also helps to overcome deflation and keep inflation close to the target mark.
  • Reflation also leads to lower interest rates.  It can directly affect infrastructure and other economic activities, requiring significant capital expenditure and having a long development period.
  • Reflation also leads to an increase in output and the index of output as more and more factories are set up to meet rising consumer demand and output.

What Are The Cons Of Reflation?

  • Reflation can lead to an excessive supply of money in the economy and can also lead to hyperinflation in the economy if managed properly.
  • It leads to a government deficit, which means that the government needs to borrow foreign funds from other countries to increase the money supply in the economy.
  • Reflation can lead to high indebtedness and excessive lending by commercial and government banks in the economy, leading to non-performing assets in the banking industry.

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What Is Reflation Stocks

Shares of banks and financial companies, industry, energy and small capitalization benefit from inflation.  Cyclical stocks such as car manufacturers, airlines, furniture retailers, clothing stores, hotels and restaurants also tend to benefit. 

Riskier and small-cap stocks typically do better than large-caps during reflation.  During a period of reflation, bond yields rise as investors anticipate a surge in economic growth and inflation.

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How Reflation Stocks Beat the Stock Market

Stocks outperform inflation when there is growing optimism about economic growth and the economy returning to normal.  Consider energy, material and travel supplies. 

Value stocks consist of sectors such as utilities, defense and consumer staples, which provide consistent returns and perform best when interest rates and growth expectations are low. 

They are the best choice in low growth and low interest rates.  Growth stocks have been lower in recent months after leading the way in 2020. 

Conclusion

Techniques used by politicians include corporate and income tax cuts, increased infrastructure spending or, as recently witnessed in the context of the pandemic, handing out US cash on the fiscal policy front.  On the monetary front, central banks will cut interest rates to reduce the cost of borrowing and remove incentives for depositors.

Also, if a major contraction occurs, such as the Great Recession or the onset of the coronavirus pandemic, monetary authorities may choose to buy government and corporate bonds and lower yields, encouraging investors to take on more risk.

Reflation Frequently Asked Questions

What Does Reflation Mean For Investors?

When the economy is in “reflation” mode, it tends to be good for commodities and stocks. Reflation favour small-cap companies rather than large ones; cyclical sectors such as energy, resources, financials, consumer discretionary and technology stocks.

Does Reflation Mean Means Rising Bond Yields?

Yes, reflation also means rising bond yields, which has already been one of the defining trends of 2021.  But again, this is part of normalization.  Bond yields are simply returning to pre-pandemic levels, which were already very low by historical comparisons.  Therefore, good reflation grams would be stocks and funds, which tend to do well when rates tend to rise.

What Kind Of Stocks Does Reflation Benefit?

  Shares of banks and financial companies, industry, energy and small capitalization benefit from inflation.  Cyclical stocks such as car manufacturers, airlines, furniture retailers, clothing stores, hotels and restaurants also tend to benefit.

Is Bitcoin A Hedge Against Inflation?

Reflation occurs against the background of higher inflationary expectations.  Some investors view Bitcoin as a hedge against inflation due to its limited supply.  Thus, Bitcoin’s appeal may increase during a reflationary period.

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