It does not change the fact that consumer price inflation negatively correlates with equity returns in the most recent decades for most of the time. How you pin and normalize it is just games, played.
So I think you are now deciding that this business of inflation and equities is a little more complicated than it might have first appeared. The first order effect is as I pointed out. Both anticipation of inflation and actual mild inflation generally has the effect of inflating equity prices, and largely for the reason I illustrated in my explanation suited for a fifth grader. There is also some positive feedback via nominally higher earnings. But beyond that it gets more complicated.
You're very likely to see additional effects illustrated soon enough, as I anticipate inflation kicking up more. We already have some inflation and that has, so far, helped push up equities, but the main driver of stock prices in the Trump era, however, was stepped up outside money (big deficits), a weakened dollar due to very low rates, and Soros reflexivity (which see).
What then might cause stocks to decline in an inflationary environment? Such an effect is not due to inflation per se but to the feds response to it. If the fed senses inflation is going higher than they would like, their standard response is to sell bonds . This drains reserve accounts, pushes down bond prices,raises rates, and strengthens the dollar. It has a cooling effect on the economy, weak at first, and a similar effect on the equities market.
During the early phase of the great recession, rather than selling bonds the fed was a big buyer. We were in a deep recession, and there was roughly zero inflation. Selling bonds caused bank reserve accounts to swell, but there was little demand for credit. Rates plummeted to just short of zero. Low rates weaken the dollar and cause it to be sold (see the dollar futures for that period). What happened to the market? It began to recover and move sharply upward. If you look at dollar futures during the period of heavy Central Bank QE, you will note the futures and stock market moving in lock step, but in opposition: dollar down, market up. As the dollar was declining in value in the forex markets, equities were rising reflecting the weaker dollar, but curiously there was little price inflation other than in equities, because demand for goods and services was down. Rates quickly dropped to near zero and stayed down there for a protracted period. In the latter stages of the recovery we began to reach full employment. If you examine the dollar futures for that period, you will note that the hold the futures earlier exhibited on the equities market began to weaken as additional factors began to play a more prominent role.
At full employment, that we had prior to the pandemic, and with moderate to low inflation, the market began to take off, as the fed kept rates historically low. We are now, I think, approaching the end off this period of rapid market appreciation in combination with low inflation and a relatively weak dollar because of extraordinarily low rates. The market has been driven by the factors I mentioned at the beginning of my post, Soros reflexivity and, of course, ever present human irrationality...
What will be next. Please tell me if you know! But I can say what I think is most probable. The great job the present administration is doing in managing covid vaccination should lift us largely out of the pandemic by Fall. The stimulus package, however, is very likely to cause an acceleration in inflation later this year. That will depend on the rate of recovery from the pandemic and how long the fed waits before they return to bond selling and begin to drain reserves. This will drive bond prices down and rates up. [we are seeing the anticipation of this right now in the bond markets]. Bond selling by the fed should have a cooling effect on the market and we should get a correction, perhaps sooner than expected based on anticipation of fed action.
When the fed sells bonds and drains excess reserves, what they are doing in effect is side tracking some of the money ("outside money", as opposed to "inside" or credit money) that the Treasury spent into the economy as part of the stimulus. I am pretty sure the fed will have to sell at some point to keep inflation under control. The economy should really boom under Democratic leadership, as the Democrats always favor demand side stimulus. The danger is too much outside money left in the economy for too long, that will cause excessive inflation.
