February 1, 2011


Powerful evidence that the big problem is demand, not structural (Money Illusion, 1/31/11)

Almost a year ago David Glasner mentioned that he was working on a similar study, this time estimating the time-varying correlation between US inflation expectations and US equity prices. He has frequently sent me very significant results, but I held back from mentioning them in order to let him get the project completed before publicizing the results. He has now placed the paper at the SSRN web site, where others can read it. In the meantime I notice that others have observed this pattern, indeed the commenter Gregor Bush recently mentioned some similar results.

It is well known that there is normally little correlation between US inflation expectations and US stock prices. Higher inflation might boost stock prices if associated with growing aggregate demand, but higher inflation can also lead to expectations of tight money, or higher taxes on capital, since capital income is not indexed. Indeed the high inflation of the 1970s seems to have depressed real stock and bond prices. In general, the stock market seems content with the low and stable inflation of recent decades, at least judging by reactions to changes in inflation expectations.

David looked at 8 years of data, from January 2003 until December 2010, and divided the sample up into 10 sub-periods. He found almost no significant correlation between inflation expectations (TIPS spreads) and stock prices (S&P 500) until March 2008. (Actually, there was a modest positive correlation during the first half of 2003, another period when people worried about excessively low inflation.) After March 2008, the correlation was highly significant, and positive. Right about the time where the US began suffering from a severe AD shortfall, the stock market began rooting strongly for higher inflation. And it still is, even in the most recent period. Money is still too tight.

There is no way to overstate the importance of these these findings. The obvious explanation (and indeed the only explanation I can think of) is that low inflation was not a major problem before mid-2008, but has since become a big problem. Bernanke’s right and the hawks at the Fed are wrong.

Posted by Orrin Judd at February 1, 2011 7:03 AM
blog comments powered by Disqus