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.
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.