There's a rumor going around that the crowd's worried about inflation. Tim Bond of Odey Asset Management speaks for many of this persuasion when he writes in the Financial Times that "the rise in inflation has been the main factor responsible for the sharp slowdown in global growth since the start of the year." Normally, worrying about pricing pressures is an accurate description of how the capital markets respond to higher inflation expectations, and rightly so. Inflation is a corrosive force that eats into wealth. But these aren't normal times.
As a barometer of how abnormal things are, consider the unusually tight relationship between the stock market and the market's inflation forecast, as defined by the yield spread in the nominal 10-year Treasury less its inflation-indexed counterpart. Normally, there's minimal correlation between price changes in the stock market and the market's inflation outlook. The two markets more or less go their separate ways. But in the wake of the financial crisis in late-2008, the normal state of affairs has given way to aberration, as the chart below shows.
click to enlarge
Over the past year, for instance, the stock market's moves have been tightly correlated with changes in inflation expectations. Equities tend to rally when the Treasury market anticipates higher inflation, and vice versa. This relationship suggests "that investors don’t fear inflation, they yearn for it," as David Glasner explains. A formal economic explanation for what's happening can be filed under the heading of the "The Fisher Effect Under Deflationary Expectations," the title of a paper by Glasner.
The source of the problem, as Charles Evans of the Chicago Fed suggests, is an erosion of the central bank's credibility though a monetary policy of passive tightening. Speaking at a conference yesterday, Evans reviewed the challenges and the framework for a solution, if only a partial one:
Given the economic scenario and inflation outlook I have discussed, if it were possible, I would favor cutting the federal funds rate by several percentage points. But since the federal funds rate is already near zero now, that’s not an option. To date, the Fed’s policymaking committee, the FOMC, has used a number of nontraditional policy tools to impart greater financial accommodation. I have fully supported these policies. However, I would argue for further policy actions based on our dual mandate responsibilities and the strong impediments of the financial crisis.
Evans goes on to say that the "current financial conditions are more restrictive than I favor, in part because households, businesses and markets place too much weight on the possibility that Fed policy will turn restrictive in the near to medium term." Marcus Nunes simplifies the issue and simply notes that Bernanke "loses it," a reference to the Fed head's former promise to Milton Friedman that he understood the implications of the Fed's past mistakes in the 1930s and would do better in the future.
Changing the expectation that the Fed won't do more won't be easy, in part because central banks have fought long and hard to promote their inflation-fighting credentials and, well, it's hard to teach old dogs new tricks. But inflation fighting at the moment isn't appropriate, according to Evans: "Given this strong anti-inflationary orientation of central bankers, appropriate policy actions may face a credibility challenge of a different nature than we are used to talking about — can conservative central bankers be counted on to commit to keeping interest rates low in the event inflation rises above their long-run target?"
The answer seems to be "no," or so the high correlation between the stock market and inflation expectations imply. If there's any change, we'll likely see it in a disconnect between equity prices and the Treasury market's outlook for inflation. Meantime, the (unfulfilled) yearning continues.