Inflation Dynamics and Their Impact on Global Financial Markets: A Time Series Approach to Risk Modeling

Abstract

This paper examines the dynamics of inflation and the impact of inflation uncertainty on various asset classes. The results are somewhat surprising. Although inflation uncertainty had the most significant impact on commodities during normal times, this relationship reverses as inflation uncertainty sets in, with commodities underperforming and portfolio managers returning to the 10-Year Treasury as a safe asset. In addition, an equally weighted portfolio yielded higher returns during stress periods than normal periods, though volatility also increased. These findings suggest that inflation hedges depend on the regime and that portfolios can achieve higher returns in stress periods if properly managed. Motivated by the 2021-2023 inflation surge, during which markets were repeatedly caught off guard by unanticipated CPI increases, this paper addresses the effectiveness of ARIMA modeling in measuring inflation surprises, the ability of GARCH to model inflation uncertainty, and the extent these variables explain return dynamics across equity, fixed income, commodity, and currency markets. Using monthly U.S. data from 2000-2024, this paper applies a two-stage ARIMA-GARCH analysis to isolate unexpected inflation and estimate uncertainty, then examines effects across major asset classes and constructs an equal-weighted portfolio.