Sober Look: Equity prices vs. inflation expectations

Many people are asking what impact the Fed’s more aggressive easing will have on various asset prices. One bit of informed analysis on equity prices based on the last three years data comes from the reliable Sober Look:

In recent years we’ve seen a clear indication that inflation expectations and US equity prices are correlated. Certainly once inflation reaches a certain level (by some estimates 4%), the relationship will break down and even reverse. However in the current environment deflationary risks drive this relationship. In other words we have an aggregate demand problem rather than any supply constraints. Expectations of price increases are a sign of a potentially stronger demand growth and higher margins, which is a positive for shares. The scatter plot below shows the relationship between the US equity prices and TIPS-implied (2×2 breakeven) inflation expectations over the past 3 years. The correlation has been surprisingly stable (around 0.86).

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