Rising Inflation Expectations Work Their Magic

The S&P 500 rose by almost 2% today, closing at 1395.95, the highest level since June 2008, driven by an increase of 6 basis points in the breakeven TIPS spread on 10-year Treasuries, the spread rising to 2.34%. According to the Cleveland Federal Reserve Bank, which has developed a sophisticated method of extracting the implicit inflation expectations from the relationship between conventional Treasuries and TIPS, the breakeven TIPS spread overstates the expected inflation rate, so even at a 10-year time horizon, the market expectation of inflation is still well under 2%. The yield on 10-year Treasuries rose by 10 basis points, suggesting an increase of 4 basis points in the real 10-year interest rate.

Since the beginning of 2012, the S&P 500 has risen by almost 10%, while expected inflation, as measured by the TIPS spread on 10-year Treasuries, has risen by 33 basis points. The increase in inflation expectations was at first associated with falling real rates, the implied real rate on 10-year TIPS falling from -0.04% on January 3 to -0.32% on February 27. Real rates seem to have begun recovering slightly, rising to -0.20% today, suggesting that profit expectations are improving. The rise in real interest rates provides further evidence that the way to get out of the abnormally low interest-rate environment in which we have been stuck for over three years is through increased inflation expectations. Under current abnormal conditions, expectations of increasing prices and increasing demand would be self-fulfilling, causing both nominal and real interest rates to rise along with asset values. As I showed in this paper, there is no theoretical basis for a close empirical correlation between inflation expectations and stock prices under normal conditions. The empirical relationship emerged only in the spring of 2008 when the economy was already starting the downturn that culminated in the financial panic of September and October 2008. That the powerful relationship between inflation expectations and stock prices remains so strikingly evident suggests that further increases in expected inflation would help, not hurt, the economy.  Don’t stop now.

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12 Responses to “Rising Inflation Expectations Work Their Magic”


  1. 1 Marcus Nunes March 13, 2012 at 8:04 pm

    David
    I hope I´m wrong, but this was my interpretation of the FOMC statement today:
    “In English: We expect the economy will remain weak going forward and so that everyone is on the same page we will keep the FF rate at exceptionally low levels for a long time. Or, even more “transparently”: Don´t expect us to act to change that expectation!”

  2. 2 foosion March 14, 2012 at 3:33 am

    Another translation: the inflation hawks aren’t ascending and we won’t do anything to harm the slight improvements in the economy, even if crude oil and gasoline prices (mentioned explicitly) cause a temporary uptick in inflation.

    The market, real rates and inflation expectations all went up as a result of the same underlying cause.

  3. 3 dwb March 14, 2012 at 8:49 am

    unfortunately i expect the trio of igits on the FOMC who are excessively focused on commodity price inflation to come out and tamp out any green shoots. The 2% inflation target is really a maximum, not an average. I wish it were not the case, but the fact that any new operations have to be “sterilized” says it all.

  4. 4 Julian Janssen March 14, 2012 at 5:55 pm

    @Mark:

    Maybe a better translation is: “Things still suck, live with it. We’ll try not to make things even worse than our inaction is already making them.”

  5. 5 Tas von Gleichen March 14, 2012 at 10:12 pm

    big money can be made knowing that interest rates eventually have to go only one way which is up. Knowing Ben Bernanke he is going to give us a lot more of helicopter drops.

  6. 6 David Glasner March 20, 2012 at 9:32 am

    Marcus, foosion, dwb, Julian, According to the Cleveland Fed’s estimates, inflation expectations are still below 2%, so there is still room for improvement. That combined with some improvement in the real economy, perhaps because the real economy is adjusting to a lower level of inflation expectations may be allowing a minimal recovery to get under way, three and a half years after the bottom fell out.

    Tas, Six months from now, let us all know how much money you have made.

  7. 7 Ibhonkk April 5, 2012 at 4:19 am

    FWIW, Jim Rogers “endorsed” Ron Paul, although he calmis to be apolitical, in a very interesting series of interviews on FT.com, where he reiterated his preference for agriculture, renminbi, swiss francs and yen, although a lot of your readers seem not to like the guy (while paralleling his strategies).


  1. 1 Links for 2012-03-14 | FavStocks Trackback on March 14, 2012 at 12:28 am
  2. 2 Chuck Norris just pushed S&P500 above 1400 « The Market Monetarist Trackback on March 15, 2012 at 2:13 pm
  3. 3 Inflation Expectations: “Loosing traction” | Historinhas Trackback on March 16, 2012 at 11:59 am
  4. 4 Links for 2012-03-14-Economic Issue | Coffee At Joe's Trackback on March 29, 2012 at 11:01 pm
  5. 5 Expectations metamorphosis – what does it signal? | Historinhas Trackback on September 15, 2012 at 8:09 pm

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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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