Where’s Inflation When You Need It? Or Do We Need It?

Some economists say that more inflation is (still) just what the American economy needs to escape from a half-decade of sluggish growth and high unemployment. A New York Times article over the weekend advises that “as Federal Reserve policy makers prepare to meet this week, there is growing concern inside and outside the Fed that inflation is not rising fast enough.”

Using the last several months as a guide, the market’s inflation forecast has been running in the low-2% range. As of Friday’s close, the yield spread for the nominal 10-year Treasury less its inflation-indexed counterpart is 2.19%. After this proxy of inflation expectations dropped in the spring, it’s remained in the low-2% range ever since.

If this is a problem, Mr. Market’s not worried. US stocks continue climb, closing Friday at an all-time high. It’s clear that the equity market and inflation expectations are no longer joined at the hip. After the 2008 financial crisis that brought the economy to its knees, stock prices and inflation expectations have been tightly linked. But the connection faded earlier this year and stocks have continued to climb while the market’s outlook for inflation has stayed flat at a relatively subdued level.
One could interpret the new divergence between inflation and stocks as a sign that the economy has healed and so the crowd has moved on by pricing assets in something more akin to a “normal” state of affairs, which is to say relatively low and stable inflation is again considered bullish. Maybe, but the recent uncertainty unleashed by the government shutdown and the delay of economic reports will keep everyone guessing for a bit longer.
Meanwhile, “weighed against the political, social and economic risks of continued slow growth after a once-in-a-century financial crisis, a sustained burst of moderate inflation is not something to worry about,” writes Harvard’s Ken Rogoff, the Times article notes. “It should be embraced.” But for the moment, it’s not the only game in town for igniting animal spirits in the stock market.
The question, of course, is whether a lesser level of inflation expectations is a sign of new headwinds for the economy or a sign that the Fed has more control over maintaining inflation at its 2% inflation target? The answer, to cite one of Ben Bernanke’s phrases of late, will be data dependent. Based on September’s soft employment report, there’s reason to wonder if the macro trend is slowing. Why, then, is the stock market rising to new highs? One theory is that the government-induced pop in economic uncertainty via the fiscal follies has delayed the Fed’s tapering plans. In turn, that’s inspired another round of buying.
By that reasoning, the equity bulls appear to be hoping for wobbly economic news, which will extend quantitative easing longer. In that case, one might wonder if the stock market has assumed the traditional role of the bond market in that a weaker macro trend is considered bullish. The new abnormal, it seems, comes in more than one flavor.