What's the Connection Between Inflation and Stocks?

by: Toro

The topic of how inflation effects stocks is a complicated one, and is a subject which I fell that I won't be able to do justice. However, I believe that the term "inflation" is not limited to the term referenced in the common nomenclature, where "inflation" means the rise in prices. Inflation, in my opinion, has a more expansive definition.

There is a branch of economics known as The Austrian School. I believe the Austrians have nailed the definition of "inflation," a definition that differs from conventional economics. To the Austrians, inflation is not just a rise in consumer prices, as often argued by conventional economists. Instead, inflation is an excess expansion of the money supply. A rise in consumer prices is symptomatic of inflation, not inflation unto itself. Consumer prices rise because of an excess creation of money.

However, inflation can manifest itself in other ways. If there are deflationary economic forces, if the central banks gun the presses, then inflation will not show up in consumer prices. Instead, it will manifest itself in other ways, often times in asset prices. All that money sloshing around has to find a home somewhere, and it can show up in many places, such as the price of land, gold, stocks, bonds, commodities, art, wine, or even sports teams.

I believe that this asset inflation describes our current environment.

The world has experienced two highly deflationary events over the past two decades. The first was an acceleration in technology. The application of technology is almost always a deflationary event as it lowers cost curves, and expands choices for consumers. The advent of the computer and the Internet has had a profound effect on prices.

The second, and more important event in my opinion, has been the opening and rise of the third world, in particular China. The opening of China is truly a massive, once-in-a-century event, akin to the opening of America in the nineteenth century. The primary effect of China has been to increase the global supply of labor. Increasing the supply of labor is a deflationary event as it lowers the cost of production.

For a variety of reasons, central banks dislike, even fear deflation, and will do whatever they must to avoid it. The primary weapon of the central banks is the printing press. As Milton Friedman said, inflation is always and everywhere a monetary phenomenon. Therefore, if you're going to fight deflation, print money.

But, that money has to go somewhere. In the beginning of the 21st century, when the Federal Reserve did whatever it could to avoid another Japan c1991, the effect of its policies was to flood the global financial system with liquidity, which found its way into all sorts of markets, including real estate. It is no coincidence that the biggest boom in real estate in this country, indeed this planet, has ever seen began shortly after the Fed funds rate went to, and stayed at 1%.

This type of inflation - asset inflation - has the effect of keeping interest rates low. Low interest rates are good for stocks (to a point) because lower interest rates offer less competition as an asset class for stocks, and since the (theoretical) value of a stock is its future cash flow discounted back to the present, lower interest rates means the value of future cash flows are higher.

If the excess creation of money does not find its way into asset markets, and instead finds its way into consumer prices, the effects are different. If consumer prices start to rise, the holders of bonds will experience an erosion of return. To compensate, fixed income investors demand higher interest rates and bid down bonds. Higher interest rates are bad for equities for the opposite reasons why they are good for stocks - more competition for stocks as an asset class and lower values of future cash flows discounted back to the present. If rising consumer prices cause higher interest rates, then the value of stocks fall.

This is the difference between the inflation of the 1970s and today. In the 1970s, inflation manifested in consumer prices. Today, inflation shows up in asset prices.

However, those days may be coming to an end. Even the Maestro himself has been talking about higher consumer price inflation in the future.

As long as interest rates stay low, asset prices will continue to rise.