Sound money? Pah!
We need more inflation. That’s the message of stock markets. For a long time, there has been a huge correlation between US inflation expectations, as measured by the gap between 10-year Treasury yields and their inflation-proofed equivalents, and the S&P 500; since January 2008, the correlation has been 0.81 in weekly data. This is showing no sign of breaking down; the stock market’s rally since June has been accompanied by rising inflation expectations. And because national stock markets are correlated, this means there’s also a strong correlation between US inflation expectations and UK equities.
In one sense, this correlation is odd. For a long time, inflation has been terrible for shares. Stock markets slumped in the 1970s as inflation took off, and soared in the 1980s as it fell. Why, then, do investors think inflation is a good thing now?
One possibility is that they think inflation is the least painful way of reducing the real debts of households, companies and governments, which would improve balance sheets and so enable faster growth in future.
This is unlikely to be the whole story, though. The correlation between inflation expectations and share prices was also positive between 2003 and 2007, when nobody much worried about debt or balance sheet recessions. Something else, then, is going on. There are at least two possibilities:
■ Inflation expectations are actually growth expectations; for example, inflation expectations fell in 2008 as investors feared a long and deep recession, and rose in 2009 as their worst fears dissipated. And higher growth expectations encourage ‘risk on’ trades.
■ Inflation expectations measure confidence in monetary policy. If investors expect monetary policy to be loose and effective, inflation expectations will rise. And this will be good for shares partly because of the expectation of faster real growth, but also because cheap money and plenty of it encourages speculation.
There are, therefore, good reasons for a strong correlation between share prices and inflation expectations. Equally, though, there’s no guarantee the correlation will continue. Some forms of inflation, such as a rise in commodity prices due to an adverse supply shock, are bad for shares. And it could be that the correlation is only positive at the lowish levels of expected inflation we’ve had in recent years.
For now, though, the market likes the prospect of inflation. ‘“Sound money’ is sometimes bad for equities.
By Chris Dillow
Continue reading at investorschronicle.co.uk… image: Kittisak
AIER Staff
Founded in 1933, The American Institute for Economic Research (AIER) educates people on the value of personal freedom, free enterprise, property rights, limited government, and sound money. AIER’s ongoing scientific research demonstrates the importance of these principles in advancing peace, prosperity, and human progress.
