From Marcus Nunes we get this figure which helps shed some light on the recent upswing in the stock market. It shows that as inflationary expectations improve so does the stock market.
The easiest way to interpret this relationship is that when inflationary expectations rise, the market is effectively saying it expects higher aggregate demand in the future. Given nominal rigidities, the higher expected aggregate demand in turn means higher expected real growth. Ergo, higher stock prices. (For a more technical discussion on this relationship see David Glasner who first spotted this relationship.)
Note that Marcus Nunes shows in the figure how the Fed’s various monetary easing programs have been tied to trend changes in inflation expectations and the stock market. Thus, the most recent developments might also be attributed to the Fed’s new long-run interest rate forecasts which is not on the figure.
For me the big take away from this picture is that all this time the Fed has been playing with us. If the Fed’s timid, piecemeal programs listed on the figure above can systematically affect the stock market, then just imagine what would happen if the Fed had gone nuclear and adopted a nominal GDP level target. The stock market would be way up, balance sheets would be stronger, the economic outlook would be vastly improved, and the economy would be back on path to full employment.
Update: Given my claims above, I was curious to see how close the TIPS-created expected inflation series tracked the nominal GDP forecasts provided in the quarterly Survey of Professional Forecasters. So I transformed the 5-year expected inflation series into a quarterly average and plotted them against the forecasted growth of nominal GDP over the next four quarters. Here is what I got:
This indicates that my interpretation of the expected inflation series as an implicit forecast of expected future aggregate demand is appropriate, at least for now.
This post originally appeared at Macro and Other Market Musings and is posted with permission.