It's still a mystery… for now. The sharp divergence between rising stock prices and falling inflation expectations has persisted since February. It's unclear what this striking uncoupling means, but surely it signals a change of one sort or another for monetary policy, the macro trend, the capital markets... all of the above? For now, the only point of clarity is that equities are no longer joined at the hip with changes in the market's outlook for inflation. It's the end of the new abnormal, the positive link in recent years between stocks and inflation expectations, based on the yield spread between the nominal 10-year Treasury and its inflation-indexed counterpart. The question is what comes next?
One theory is that we're receiving flawed signals from the inflation-indexed Treasury market and so the divergence isn't as dramatic as it appears. That's a possibility, but other measures of inflation expectations have been sliding recently as well, albeit modestly. The Cleveland Fed's estimates of the inflation outlook are softer these days. Inflation predictions from economists are also lower, according to last week's update of the Livingston Survey via the Philadelphia Fed.
In other words, the weaker outlook for inflation looks rather convincing, and it follows a period when concerns that the Federal Reserve will soon start tapering its bond buying program, which has been partly designed to keep inflation stable. By that standard, the policy is failing. Based on the Treasury yield spread, the market's outlook for inflation was 2.14% on Friday, or down from 2.6% in February. That's near a one-year low, and the recent trend implies that we'll see even lower levels in the near term.
But the stock market is unconcerned, and it appears that the Fed isn't worried either. "Should inflation expectations begin to fall, we might need to take action to defend our inflation goal, but at this point, I do not see inflation or deflation as a serious threat in the near term," Federal Reserve Bank of Philadelphia President Charles Plosser said in mid-May.
Several weeks later, it's clear that inflation expectations are still falling. It's a mild decline and so perhaps it's not all threatening. But if the outlook for pricing pressure continues to retreat, something will have to give. There are several possibilities, some good, some troubling. On the bright side, the bullish view is that the economy's recovering even as inflation expectations fall - a new macro paradigm of sustainable growth with unusually low inflation. Perfection, in other words. We certainly have one side of the equation, but the other still looks vulnerable. The weeks ahead may tell us if it's time to revise this profile, for good or ill.