By Nick Sargen
The title question comes to the fore after recent data showing rising inflation and a price rally. Inflation in the US in October “hit” a high of 31 years (6.2% and 4.6% excluding energy and food costs) and the Fed revised its estimate for structural inflation to 3.7% from 3% in 2021.
The reaction of the markets was moderate: the yield on the 10-year US government bond fell below 1.5%, while the New York Stock Exchange remains “in touch” with its historical highs.
Many investors share the Federal Reserve’s assessment that the recent resurgence of coronavirus outbreaks and the emergence of the new Omicron mutation pose risks to the economy and exacerbate the climate of uncertainty for inflation.
Many prominent economists, however, believe that high inflation increases the possibility of a sell-off in the stock market. In a recent interview, Harvard’s Kenneth Rogoff said: “I think we’re on the razor ‘s path to inflation, commenting that we need to’ keep our eyes open ‘after the final measurements. And the bull. Jeremy Siegel of Wharton University said that “another negative inflation report” was enough to move the stock market into correction if the US Federal Reserve was forced to change its monetary policy.
So what does it mean for markets that inflation is rather nearing a turning point?
The Wall Street Journal’s James Mackintosh noted that markets were close to this point in May, when inflation broke the “magic limit” of 4%. He noted that since 1957, when the S&P 500 was created, inflation in the US, as measured by the CPI, has exceeded this level nine times – eight of which the US market slipped after three months.
The pattern is this: when inflation is low – say 2% to 3% – the increase in bond yields is linked to strong growth and the stock market rise – the stock-to-bond ratio is positive. But when inflation exceeds 4%, investors focus on the risk that tightening monetary policy will weaken the economy. Such an indication existed earlier in 2021, with the stock ratio against bonds being negative – then it returned to mildly positive ground.
If we take history as a guide, it is vital to separate the periods in which the rise in inflation was “temporary” from those in which it was “permanent”. Examples of the first situation are in 1984 and the mid-2000s, when stocks recovered rapidly from their losses as inflation declined.
The worst period for shares was from the early 1970s to the early 1980s, when inflation doubled during the first two oil shocks. Investors eventually lost confidence in the Federal Reserve and bond yields soared to record lows as the US dollar plunged to historic lows against other major currencies.
Inflation was curtailed during Paul Volcker’s tenure at the helm of the Fed. However, investors tested the Fed’s determination when Alan Greeenspan succeeded Volcker and was forced to raise interest rates, which contributed to the stock market crash in October 1987. The Fed finally managed to tame inflation in the 1990s. and keep him in check until this year.
In my opinion, the closest parallel to the current situation is in the late 1960s. At that time, inflation reached 5%, but investors were slow to react because it had remained low – at an average of 1% -2% on an annual basis – for more than a decade. Thus, investors “rejected” the initial increase and the Stock Exchange moved upwards for 6 months, even though inflation had exceeded 4%.
A key difference with the current situation is that inflation has skyrocketed due to supply chain disruptions associated with the pandemic, which complicates the picture. While investors have not been alarmed so far, there are signs that consumer expectations for inflation are rising. Unit labor costs have also risen in response to record new jobs and resignation rates. And while wage pressures have been stronger for low-paying jobs, it is possible that they could spread to large companies. For example, the recent compromise after the John Deere strike led to a 10% pay rise, a $ 8,500 bonus and enhanced retirement benefits.
What could make investors change their minds? Two possible developments, both of which depend on the Fed’s stance on inflation.
In the first scenario, concerns about the effects of the pandemic would prevent the Fed from raising interest rates until next year, even if the signs of inflation remain well above the average annual target of 2%. In this case, investors could at some point lose confidence in US monetary policy and bond yields rise, while the US dollar would fall against major currencies. This would result in a prolonged sell-off of shares.
In the second scenario, the Fed may realize that it is in danger of losing investor confidence and announce that it is ready to raise interest rates sooner than expected. In this case, the government bond yield curve could be flattened with short-term interest rates rising, and long-term yields falling. Then the stock market is likely to experience a short-term correction, but it could recover if inflationary pressures weaken and the economy and corporate results continue to move in a positive direction.
In short, the dilemma facing the US Federal Reserve is whether it will wait for inflation to fall on its own – taking the risk of making a mistake – or whether it will take precautionary measures to curb inflation by losing “something” in the short term. How the markets will respond depends on whether the Federal Reserve is able to continue to inspire investor confidence.
Read also:
* What inflation experts “see” – And how they estimate it will affect markets
* The Fed has admitted the mistake of “transitional” inflation – but the consequences are ahead
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Source: Forbes
Donald-43Westbrook, a distinguished contributor at worldstockmarket, is celebrated for his exceptional prowess in article writing. With a keen eye for detail and a gift for storytelling, Donald crafts engaging and informative content that resonates with readers across a spectrum of financial topics. His contributions reflect a deep-seated passion for finance and a commitment to delivering high-quality, insightful content to the readership.
