Lorenzo Ranaldi

This paper shows how inflation affects the real economy through bank balance sheets: unexpected inflation erodes banks’ net worth by devaluing long-term assets relative to short-term liabilities, constraining lending and depressing real activity. Using a century of data for 18 advanced economies, I document that inflation surprises reduce aggregate loans and shrink bank balance sheets, even in absence of contractionary monetary policy. To shed light on the mechanism, I exploit rich micro-level data on bank-firm relationships, and show that inflation-exposed banks cut credit supply when inflation increases, and their borrower firms scale back investment due to credit rationing. As such, inflationary pressures on banks can counteract the traditional debt-inflation benefits.

We examine the relationship between inflation surprises and asset returns across 18 advanced economies from 1870 to 2023. Using newly constructed historical data on inflation surprises, we document that stocks, housing, and government bond returns decline persistently following unexpected inflation increases. Leveraging our long-run panel, we point to monetary policy responses to inflation, rather than the inflation source, as the key macroeconomic channel driving this nexus. Consistent with this mechanism, we find that real asset returns decline substantially less in response to inflation surprises under fixed exchange rate regimes, when monetary policy is constrained. These findings underscore the critical trade-off central banks face between price and financial stability when responding to inflationary shocks.