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Higher Inflation Does Not Automatically Means Higher Stock Market Prices

September 23, 2020 By Mircea Vasiu

One of the reasons why investors flock to the safe-haven assets is to protect against inflation. For instance, buying gold traditionally protects against inflation when gold is denominated in the same currency.

With central banks lowering the interest rates to the zero level, investors had a hard time finding the much-needed yield. As such, they flooded the stock market.

Higher stock market prices are a must in the context of the new Fed’s mandate of Average Inflation Targeting (AIT). The willingness of the Fed to let inflation overshoot the 2% automatically means higher stock prices.

Correct? Not really.

Moderate Inflation Helps Stocks

Historically, if we define moderate inflation as inflation between 1% and 2%, that is the level when the stock market performed best. In other words, inflation is far enough from the zero level, so to avoid deflation, but not above 2%.

Every time inflation exceeds 2%, market valuations inevitably come down. Therefore, higher inflation than 2% is not necessarily bullish for stocks.

The Fed did not make it clear so far how it intends to reach the 2% AIT target. However, in the few speeches that came out after the last FOMC statement, we may form an idea about what members of the Fed have in mind.

For instance, Neil Kashkari, a dove in the FOMC, wants to see inflation above 2% for twelve months in a row before raising rates. For the first time since the AIT was introduced to the markets in August at the Jackson Hole Symposium, we have an idea about what may trigger a rate hike.

Considering that the last dot projections showed the Fed willing to keep rates at current levels until 2023 include, we may conclude that the 12-months period that Kashkari talks about will not be anytime before 2023.

To track the progress, all eyes should be on the PCE – Personal Consumption Expenditure, the Fed’s favored measure to track inflation. If the PCE shoots above 2% for more than a year, investors will start betting on a rate hike.

However, the prospects of a rate hike so far away in the future leaves so many present questions unanswered. Like, for instance, what if inflation does not reach 2% for many years from now? If we look at Japan, that very well may be the case in the U.S. too, especially given the pandemic.

One thing we can learn from the current AIT phase. Way higher inflation than the 3% or more will likely trigger higher stock prices, but the capital gains are eroded. Hence, for the AIT to have a positive effect on the stock market, the Fed should allow only modest increases above the 2% level.