The tight correlation in the last several years between the Treasury market’s inflation outlook and the stock market (S&P 500) has been a reliable barometer of macro conditions in a period that I like to call the new abnormal. As I discussed last October, in normal times, there’s minimal correlation between equity market prices and inflation expectations. Indeed, higher inflation is generally considered troublesome above a certain level… most of the time. But normality gave way in the wake of the financial crisis in late-2008, which brought us a new paradigm. And so, falling inflation expectations, until further notice, are accompanied by falling stock prices; if the trend persists, it leads to a deterioration in macro conditions. This illness will end one day, but not yet. (For the theory behind this empirical fact, see David Glasner’s research paper on the so-called Fisher effect.) Hold that thought as we consider the latest signals from the stock market in the context of inflation expectations and the implications for the economy.

As the chart below shows, the past several weeks have witnessed an unusually large divergence between stock prices and inflation expectations. In particular, the equity market has climbed quite a bit while the market’s inflation forecast has remained flat and in recent trading sessions has dropped under 2% for the first time this year. Equity prices have popped in large part because recent economic news has been relatively favorable, including the sharp decline in new jobless claims, which suggests that the labor market will perk up. But the rise in equity prices hasn’t been accompanied by an increase in inflation expectations. That’s a worrisome sign in the current climate, given what we known about the new abnormal from the last several years–all the more so when you recognize that the economy is still struggling. Either the stock market is set to tumble, which would all but confirm a new round disinflationary expectations; or the market’s inflation outlook is poised to rise, which would provide some support for the bulls and expectations for continued economic growth. Why might inflation expectations rise? More encouraging news on the economy would do the trick. It’s a virtuous cycle that we need to see right now. On that note, the January numbers will begin arriving this week and so we’ll find out if the recent optimism finds support in the data for the new year. But with the stock market’s annual change at around 2.7%, we are, it seems, at a new crossroads once again. If equities fall into the red, that would be one more weight in favor of the recession forecasts. A negative annual return for stocks isn’t necessarily fate, but history reminds that recessions and the relatively rare sight of losses in the S&P 500 on a year-over-year basis go hand in hand.

The good news is that this time, in contrast to 2010, the annual rate of change in the money supply isn’t low or falling. As the next chart shows, M2’s pace of growth is around 10% these days vs. the tepid 1%-2% level at this time a year ago. Why does that matter? Money demand is still strong and if that demand isn’t satisfied in the current climate of anxiety, the economy is likely to suffer.

The question is whether the current monetary policy will suffice? Yes, compared with this time last year, the Fed is relatively more accommodative, given the pressures of the new abnormal. But as economist David Beckworth reminds, it’s not clear that the central bank is doing all it should be doing to offset the macro headwinds. Ultimately, deciding if monetary policy is too tight or too loose can only be answered in the context of money demand. There is no absolute right or wrong with money supply levels; much depends on how it relates with current appetite for liquidity.
In normal times, falling inflation would be a good thing. In the current climate, it can become toxic if inflation is allowed to fall too far. For now, it’s not yet clear if inflation is set to fall. The fact that inflation expectations have been relatively stable at around 2% over the last several months has been an encouraging sign, although a higher inflation outlook of 2.5% to 3.0% would have been even better. But all bets are off if inflation expectations trend lower in the weeks and months ahead. If so, the stock market may follow. In that case, the Fed needs to up its game with another round of quantitative easing, i.e., injecting more liquidity into the system to sate higher money demand. History is quite clear on this point: when money demand rises, it must be met with an increase in supply. If not, something has to give, and it’s usually prices. If disinflation/deflation is allowed to fester, it eventually infects the broader economy.
Falling stock market prices are usually the canary in this coal mine when the new abnormal prevails, and inflation expectations may precede the early warning of trouble ahead via equity prices. True, recent economic data has been modestly encouraging, as I’ve been pointing out on these pages recently. It’s also clear that last year was recession free. But it’s the near-term future that’s open for debate… again.
It’s not yet obvious, at least to me, what comes next. There are some analysts predicting that a new recession is near, although that forecast isn’t confirmed in the latest economic numbers. The situation is quite fluid, and so much depends on the Fed policy decisions in the weeks ahead.
As for this week, the early clues about the economy’s strength, or lack thereof, for January will be dispatched in the days ahead. Meanwhile, keep an eye on the divergence between the stock market and inflation expectations. If it continues to widen, there’ll be little if any margin for disappointment in the next batch of economic updates.