The S&P 500 rose 3.4% today, closing at 1284.59, the highest close since August 1. And not coincidentally, the breakeven TIPS spread – a slightly upward biased estimate of inflation expectations — on a constant maturity 10-year Treasury rose 9 basis points to 2.18%, the highest the TIPS spread has been since mid-August.
At the end of September, after a miserable third quarter, in which both stock prices and inflation expectations dropped sharply, there was a great deal of hand-wringing (some of it my own, see here, here and here) about the prospects for stock prices and the possibility of another bear market. The economy had performed badly since the start of 2011, and the FOMC in its September meeting had held out little hope for further easing of monetary policy, the attempt to flatten the yield curve by lengthening the maturity of Fed holding being widely regarded as meaningless and ineffectual. In addition, the determined resistance of three regional Fed bank presidents, Plosser, Fisher and Kocherlakota, to any further easing of monetary policy combined with the overt hostility of prominent Republican politicians to monetary easing seemed to have tied the hands of Chairman Bernanke.
However, sometimes it really is darkest just before the dawn. The widespread expressions of despair about the future of the economy in the absence of any new measures taken by the Fed coupled with strong statements by Fed vice-chairman Janet Yellen, and by Presidents Charles Evans of the Chicago Fed and William Dudley of the New York Fed seemed to provide markets with renewed hope that the possibility of further easing had still not yet been definitively taken off the table.
Hopes for monetary easing received a further boost on October 14, when Goldman Sachs released a staff report supporting a shift in Fed policy toward targeting nominal GDP as advocated by Scott Sumner and other Market Monetarists. Thanks to revived hopes for monetary easing, the TIPS spread on the constant maturity 10-year Treasury has risen by 43 basis point since the end of September.
The chart below plots the daily change (measured in basis points) in the TIPS spread on the constant maturity 10-year Treasury and the percentage change in the S&P 500. Here is yet further evidence that the strongly positive correlation between inflation expectations and stock prices since early 2008 identified in my January 2011 paper (and discussed in earlier blog posts here and here) continues to hold.
A recent blog post by Daniel Nielson questions whether central banks can accomplish anything by targeting NGDP, because they have no credible means of achieving their objectives, but market measures of inflation expectations obviously are responding even to scraps of new information about changes in monetary policy.