The New Abnormal Is Back (Actually, It Never Left)

Surprise, surprise—stocks and inflation expectations are down. Together. Again. Surprised? You shouldn’t be. This abnormal relationship has prevailed for most of the past four years, from roughly that period of economic infamy when a certain investment bank was allowed to collapse and the linkage between markets and macro has been skewed ever since. I call this the new abnormal—the unusually high positive correlation between changes in the stock market and inflation expectations, as defined by the 10-year Treasury’s yield less its inflation-indexed counterpart. Whatever you call it, it’s still with us, and it’s a sign that the crowd still craves higher inflation. That’s likely to prevail until something approximating “normal” returns to the economic landscape. Meantime, the new abnormal rolls on.

The notion that the market’s looking for higher inflation drives some pundits batty. But it’s a prescription that the crowd prefers, at least for now. One reason: money demand is still too high—even after four years, as economist David Beckworth explains. Meantime, we’re still in a world where equities and inflation expectations move in tandem.

David Glasner details the theory behind this connection—it’s known as the Fisher effect. But theory and empirical fact aren’t enough for some folks, who ignore the new abnormal entirely and prefer instead to talk about inflation risks as a real and present danger now, today, this minute. Eventually they’ll be right, just as a broken clock tells the right time twice a day.
For now, the new abnormal is still with us until further notice. You can ignore it or accept it, but it’s not going away until the economy moves closer to normality. Exactly when that will be is open for debate. But if some of the inflation hawks have their way on matters of the fiscal cliff, the day of macro salvation may be further out than you think.