Yes, Virginia, The Stock Market Really Does Love Inflation

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.

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17 Responses to “Yes, Virginia, The Stock Market Really Does Love Inflation”

  1. 1 Marcus Nunes October 27, 2011 at 9:42 pm

    The magnitude of today´s rally was surely also influenced by the (temporary at least) relaxation of constraints in the eurozone. Markets are in such a “depressed” state that whenever something “pulls thm up” a bit, they take a “deap breath” before “going under” again.

  2. 2 Luis H Arroyo October 28, 2011 at 2:50 am

    David, there is some excessive reaction to the Euro Summit, that has not been decisive after all. The final tex is ambiguous and plaint of holes. They are not capable of turn the ECB to its function of lenders of las resort, that´s all.
    I suspect that after somo days, markets will moderate their optimism quite a lot.
    In any case, I agrre with you: market does love inflation

  3. 3 Lars Christensen October 28, 2011 at 6:44 am

    We are having a 1931 Hoover rally – and David I am afraid that I disagree – stock markets do not in general like inflation, but I will have to do a post on that.

  4. 4 David Glasner October 28, 2011 at 10:26 am

    Marcus and Luis, Agreed. The eurozone agreement as well as a better than expected number for third-quarter GDP obviously had something to do with it. But when I checked my little graph, I thought it was too good not to share.

    Lars, I also agree that markets in general do not like inflation. That is what makes it so important that in our current situation that markets actually LOVE inflation. I thought I made that clear in my paper and in earlier posts. If not, sorry. At any rate, I look forward to your post.

  5. 5 Lars Christensen October 28, 2011 at 10:53 am

    David, I am sure we do not disagree, but I am thinking of picking a fight with you to make my (our?) point more clear. In a situation of excessive monetary demand and drop in monetary demand (due to increased inflation expectations) will be strongly positive for equities, but in a situation of high inflation an increase is highly negative for equities.

  6. 6 Luis H Arroyo October 28, 2011 at 11:11 am

    Obviously, markets don´t love inflation when that can rise interest rate.

  7. 7 Marcus Nunes October 28, 2011 at 1:09 pm

    That´s why I think mentioning the I word is bad. Even among “like thinkers” it gives many the “goosebumps”. What the stock market loves is to envision (even if temporarily) the possibility that NGDP will climb towards trend.

  8. 8 David Pearson October 28, 2011 at 4:31 pm

    Commodities are up even more the past few days that Yellen, Tarullo and Dudely have signaled QE3.

  9. 9 Benjamin Cole October 28, 2011 at 10:01 pm

    I wonder who are these naysaying weenies, like Daniel Neilson, who stage the most peevish and feeble sentiments as barriers to NGDP targeting.

    Seemingly, no argument is too hackneyed or imbecilic to be seized upon by either fiscalists or gold-nuts to prove that NGDP targeting cannot work.

    At least Krugman has gotten one foot onto the Market Monetarist bandwagon. I wonder if the gold-nuts will ever get on board. I suppose they think it sacrilegious to print more money.

  10. 10 David Glasner October 29, 2011 at 9:19 pm

    Lars, I think that we basically agree. Except for me it is not the absolute rate of expected inflation, but the expected rate of inflation relative to the ex ante real rate of interest. When the real rate of interest is significantly above the negative of the expected rate of inflation, inflation is bad or neutral for equities, but when the negative of the expected rate of inflation is greater than the ex ante real rate of interest, people want to hold money rather than equities and you get a crash in stock prices. Ever since the crash the negative of expected inflation and the real rate of interest have been very close and that is why the market finds expected inflation so beneficial.

    Luis, I think if you read what I just wrote to Lars, you will see that it is a bit more complicated.

    Marcus, I think inflation is important because it focuses on the choice between holding assets and holding money.

    David, What do you mean by “even more?” Even more than they were up before or even more than stocks went up?

    Benjamin, Think positive. Maybe the tide is turning.

  11. 11 David Pearson October 30, 2011 at 9:21 am

    Since the latest QE3 signals, commodity prices rose more steeply than stock prices, and much more than expected inflation.

  12. 12 GeorgeK October 30, 2011 at 1:15 pm

    Traders are like sharks if they stop moving they die.

    It’s just the algos trading each other, nobody is investing based on valuations. Wall St is still just a casino.

  13. 13 Barry November 2, 2011 at 11:42 am

    Well, no. An economic recovery would cause a rise in interest rates, but I’m sure that markets would love it.

  1. 1 Scott Sumner Bans Inflation « Uneasy Money Trackback on November 6, 2011 at 9:28 pm
  2. 2 Sumner, Glasner, Machlup and the definition of inflation « The Market Monetarist Trackback on November 7, 2011 at 2:27 pm
  3. 3 Stock Prices Rose by 5% in Two Weeks – Guess Why? « Uneasy Money Trackback on August 12, 2012 at 10:46 am
  4. 4 What Gives? Has the Market Stopped Loving Inflation? | Uneasy Money Trackback on June 7, 2013 at 11:42 am

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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