Remember the old adage that a little inflation is good for stocks? That was before the disinflationary 1990s, when a little inflation was tolerable, even desirable, in the world of central banking. The reason inflation was considered good for stocks (i.e. good for corporate profits, when things like that mattered) is that inflation means companies can raise prices instead of absorbing higher input costs, such as labor and raw materials.
What's more, stocks live and operate in a nominal world, irrespective of inflation.
"Stock prices reflect nominal profits, not real profits," says Henry Willmore, senior US economist at Barclays Capital Group. "The stock price does what it does based on nominal growth." Watching financial markets recently, with stocks rallying -- the broad Wilshire 5000 Index is up 21 percent from its low in early April -- and bonds responding negatively to hints of higher inflation, one can't help but wonder if we're not back in an era where modest inflation and stocks are fellow travelers.
What's changed? The policy response, that's what. Gone is the central bank's goal of zero inflation, defined loosely as a rate low enough so as not to be a factor in business and consumer decision-making, and expressed as 2 percent or less.
The goal of zero inflation has been replaced by growth at any cost. The Fed is pulling out all the stops to prevent the NASDAQ market collapse from snowballing into an economy-wide recession.
Toward that end, it has ignored inflation warnings from auction-market indicators, such as the yield curve and spread between nominal and inflation-indexed bonds, and instead has willed that inflation be well contained.
In its latest statement accompanying the rate cut last week, the Fed actually mentioned the "I" word, only to dismiss its actuality.
"With pressures on labor and product markets easing, inflation is expected to remain contained," the Fed said in announcing a 50 basis-point reduction in the funds rate to 4 percent on May 15. (Then again, can you imagine the Fed saying that inflation was expected to come tearing out of the box and, in the same breath, slash interest rates?)
To be sure, in recent years stocks were just as likely to react adversely as bonds to an unexpected increase in the monthly consumer price index. That's because the Fed was perceived as an advocate for price stability, in both word and deed.
Take away the stick of tighter policy, and the carrot is mighty tasty.
In other words, it's not inflation that's bad for stocks; it's the central bank's response to accelerating inflation. Higher interest rates slow economic growth and reduce the discounted present value of future earnings. It's higher interest rates that are bad for stocks, not the inflation that is generally the catalyst.
"The Fed has revealed itself to be more tolerant of 3.5 percent inflation than they were a year ago," Willmore says.
"That's a reasonable inference for the stock market to draw." Steve Wieting, an economist at Salomon Smith Barney, disagrees with the idea that rising inflation and an indifferent Fed is a good combination for stocks.
"Rising inflation has predicted a bad macro-economic performance and weaker profit margins, independent of the policy response," Wieting says.
"It leads to bad pricing decisions: input costs often rise faster than prices." Of course, stocks outperform bonds in such an environment.
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