The Market and Inflation Expectations

The stock market and inflation expectations have been highly correlated lately. Are inflation expectations driving the stock market? Well, I can’t say for sure. Correlation, of course, doesn’t mean causation. But still, correlation can be very important.

Over the last nine months, every 0.1% move in ten-year inflation expectations has correlated with a 50-point move in the S&P 500.

I suspect that Ben Bernanke and his buddies at the Fed are familiar with the chart above. The issue is that the Fed is nearly out of bullets, but there are still some tricks they haven’t used. One move could be to have the market believe that inflation expectations will rise. The best part is that it won’t cost a dime if (and this is a big if) the market believes what the Fed says.

Matthew O’Brien explains in The Atlantic:

The true nature of central banking isn’t about interest rates. It’s about making and keeping promises. And that brings me to a confession. I lied earlier. Central banks don’t really buy or sell short-term bonds when they lower or raise short-term interest rates. They don’t need to. The market takes care of it. If the Fed announces a target and markets believe the Fed is serious about hitting that target, the Fed doesn’t need to do much else. Markets don’t want to bet against someone who can conjure up an infinite amount of money — so they go along with the Fed.

Don’t underestimate the power of expectations. It might sound a like a hokey religion, but it’s not. Consider Switzerland. Thanks to the euro’s endless flirtation with financial oblivion, investors have piled into the Swiss franc as a safe haven. That sounds good, but a massively overvalued currency is not good. It pushes inflation down to dangerously low levels, and makes exports uncompetitive. So the Swiss National Bank (SNB) has responded by devaluing its currency — setting a ceiling on its value at 1.2 Swiss francs to 1 euro. In other words, the SNB has promised to print money until its money is worth what it wants it to be worth. It’s quantitative easing with a target. And, as Evan Soltas pointed out, the beauty of this target is that the SNB hasn’t even had to print money lately, because markets believe it now. Markets have moved the exchange rate to where the SNB wants it.

Posted by on June 5th, 2012 at 3:34 pm


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