Measuring transitory inflation: Implications for monetary policy and stock market volatility

We present a methodology for developing a transitory inflation (TI) measure that captures persistent deviations from mean inflation, distinguishing it from underlying inflation. First, we analyze the decay rate of TI as it reverts to stationary inflation, finding that convergence typically ranges between two to four years. We then examine the impact of TI on monetary policy, demonstrating that a surge in TI increases monetary policy uncertainty and is followed by interest rate hikes by the Federal Reserve. Furthermore, we investigate how TI influences key stock market outcomes and find its impact varies across sectors and by market capitalization; overall, higher TI is associated with lower asset prices, especially for small-cap stocks, and higher stock market volatility. We also identify rising oil prices as a significant driver of TI.