Scott Sumner just posted an item on his blog pointing out how the stock market rallied today when Ben Bernanke testified that the Fed would take action to stimulate the economy if needed. Bloomberg reports:
The greenback fell the most in six months versus the euro as Bernanke said central bank is prepared to take additional action, including buying more government bonds, if the economy appears to be in danger of stalling. The Australian and New Zealand dollars led earlier gains against the currency after China’s economic growth exceeded analysts’ estimates. The euro advanced as Italian and Spanish bonds rose for a second day.
“The markets are weighing the trade-off between the potential for liquidity injections and worsening in global growth prospects,” said Aroop Chatterjee, a currency strategist at Barclays Plc in New York. “For the time being liquidity is winning out. Bernanke’s comments may take some of the focus off what markets have been trading on, which have been largely linked to European news.”
The dollar weakened 1.4 percent against the euro to $1.4166 at 12:38 p.m. in New York, its biggest drop since Jan. 13. It reached $1.3837 yesterday, the strongest level since March 11.
The Standard & Poor’s 500 Index rose 1.2 percent and the yield on 10-year Treasuries increased seven basis points to 2.95 percent.
The weakening of the dollar and the increase in the 10-year Treasury both suggest an increase in inflation expectations. If stock prices are increasing in the face of increased interest rates at which future earnings must be discounted it can only mean that investors are expecting earnings to increase faster than prices. In other words, investors expect that inflation under current conditions will increase earnings in real terms. That relationship between expected inflation and the expected growth of earning seems to have prevailed, as I showed in my paper “The Fisher Effect Under Deflationary Expectations,” since early in 2008 when inflation expectations started to falter as the economic downturn started. My data analysis only went as far as the end of 2010. The last six months show basically the same relationship except for a while when oil prices spiked in February because of the Libyan situation. I hope to revise and update the paper sometime this summer.
Scott writes:
But you might ask “weren’t the high inflation 1970s really bad for stocks?” Yes they were. Just like in the story of the three little bears, the stock market doesn’t want too much inflation, nor too little. Something for the inflation hawks to think about.
That is not quite how I would put it. Whether the market likes inflation or not depends on how high real interest rates are. If real interest rates are high, then markets can tolerate deflation. But when the real rate is already low and for sure if it’s negative, deflation, or even the very low inflation we have now, is very damaging and holds back the recovery. In the 1970s, however, nominal interest rates were at double-digit levels. At those levels, inflation provides little or no stimulus to growth, and has all sorts of negative side effects. In addition, there were supply side shocks in the 1970s, which should properly have been accommodated by monetary easing. Stock prices fell in response to the supply-side shocks not only because inflation was too high.
Uneasy Money 
David
Completely agree. Just goes to show that if instead of adopting “go-stop” (QE on, QE off) measures Bernanke came out with a NOMINAL TARGET, how much better things would be.
It´s funny how we are repeating the debates (and divisions) of 80 years ago!
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David, some in the market place is seeing this as a “Bernanke put” – and hence talk of inflationary risks and bubbles emerges once again. On the keynesian side they talk about “stimulus”. However, as Nunes acknowledges this is basically about approaching some kind of nominal target.
I think that this constant back and forth on QE-X is a great problem in terms of fundamentally re-establishing monetary equilibrium in the US economy. What is need is a clear RULE on some kind of nominal target. Sumner has convinced me that a NGDP rule would be the preferable option. Or even better lets go for some kind of “automatic” rule based on market pricing – you have yourself made that argument on a market based rule in your excellent book on Free Banking and monetary reform. This is what we need to go for.
Even though I think today’s comments from Bernanke are good news I would much have preferred that he had not need to make discretionary evaluations of income macroeconomic data as he seems to be doing now. Other than the obvious reasons for rules rather discretion stated Kydland and Prescott and other I think there are practical political reason for a rules based monetary policy. In present situation we are going to have a political discussion about the need for more “stimulus” or the risk of inflation and bubbles every time Bernanke hints at possible policy changes. That would not be the case if an automatic market based rule was in place to ensure equilibrium between money demand and money supply.
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David, NGDP growth averaged 11% beteeen 1972 and 1981, so in my view there wasn’t a single minute in the entire period where monetary easing was needed. We needed closer to 5% NGDP growth. The big reason inflation hurts stocks is that taxes on capital earnings are not indexed in America. Hence higher inflation dramatically raises the tax rate on capital, and punishes saving and investment.
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Marcus, Thanks for your comment. Ron Batchelder and I wrote a paper “Debt, Deflation, and the Great Depression,” published in a volume called Money and Banking: The American Experience in which we discussed the Goldsborough bill and the forces that opposed it.
Lars, I agree that it would be good to have a rules-based system, but I am afraid that if we get the rule wrong, it could turn out badly.
Scott, Actually, I just checked there were two quarters in the 1973-75 recession in which GDP growth was less than 5 percent. But in 1972 and 1973, NGDP was growing at almost 15 percent. Do you think going from 15 percent NGDP growth to 7-8 percent growth in the middle of a supply shock is good policy? I don’t.
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Nice blog. Keep posting–it is important to move the consensus towards easing, or higher NGDP targets.
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My view is that the “oil shock” was “caused” by the previous rise in US inflation (and the dollar devaluation after 1971) which was really a double whammy on oil exporters income. The arab-israeli war was just a “convinient excuse” to quadruple oil prices. In this case a “nominal shock” gave rise to a “real shock”. The rest is Burns bad monetary management as very well recounted by Robert Hetzel in “Arthur Burns and Inflation”.
Click to access hetzel.pdf
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It is good to have open discussion of monetary policy like this. This discourse does not occur in the MSM. Everything is pigeonholed into Hawk/Dove. This allows the powers that be to control the framing and gives the population few choices about how our affairs our managed.
This new trend of having experts weigh in with opinions on how monetary policy should ideally work allows everyone to see how far from ideal the Federal Reserve really is. It is destructive to the mythology of the Fed. Glassner/Sumner are helping to move the discussion forward, these blogs really do affect many of the thinkers in soceity. Thank you, even if I don’t agree with you two on everything.
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Gabe. I would also include, in addition to Sumner/Glasner, David Beckworth and Nick Rowe
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Agreed. The network has become a must read for anyone who wants to be current on the real debates going on.
I’d include ZeroHedge and Mises.org as well even though I know that will draw hisses and boos from this crowd. The fact is that the mainstream economists who got the housing bubble wrong (repeatably, publicly and badly wrong) were discredited and now that the NYT and WSJ are NOT the official record keepers for educated society, it is impossible to hide those skeletons from those of us who follow monetary policy closely.
Change needs to occur, whether it means NGDP targeting or some other method of making the process more fair for ALL parties is a worthy debate. It is NOT OK for the parties who ran policy the last 3 decades to continue to run things more/less the same way with no public debate and dialogue…canned press conferences are not the solution…they are a stop-gap effort at snowjobbing the public again.
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David, Going from 15% to 7% is a good policy if you plan to keep it low, and indeed eventually go lower. It’s a bad policy if you plan to bounce right back up to 11%, which is what we did.
BTW, the 15% figure was too brief to have been factored into expectations. No one in 1972 expected 15% NGDP growth to continue.
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Marcus, Sorry, but I must beg to differ. As you note the price of oil quadrupled from late 1973 to early1974. It doesn’t seem plausible to attribute an increase of that magnitude to monetary forces. That is not in any way to defend Arthur Burns, in many ways an admirable economist and public servant, who unfortunately was not up to the job he was appointed to.
Benjamin and Gabe, Thanks for your encouragement.
Scott, Back to one of those annoying little 3 percent things (a little inside joke, sorry). It’s good policy even during a supply shock? That can’t be right. Not fully factored into expectations but certainly more than 7 percent.
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@ Gabe, nothing wrong in following mises.org. I think the Mises Institute has done a great job over the years….some of the scholars there have odd views – I for example never understood how closed borders and monarchy fits into libertarian ideology, but hey what do I know. And then I don’t understand all that 100% reserve banking and gold blah blah…
And anybody who wants to study economics should read Human Action.
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Nice article, David. I quote you in my blog where I add the graphs that for me prove that “Markets love inflation…”
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