Latest figures show that CPI inflation fell to a four-year low of 2.2 per cent last month. To see why this matters, consider the gap between the unemployment and inflation rates. This has some ability to predict returns; since 1989 (when current CPI data began), the correlation between the difference between the two rates and subsequent annual real returns on the All-Share index has been 0.26. When unemployment was high relative to inflation in the early 90s and in 2009, shares subsequently did well. And when unemployment was low relative to inflation - for example, in the late 80s and in 2007-08 - shares subsequently did badly.
In part, this is because the unemployment rate predicts returns. This is because high unemployment is a sign of a weak economy, and in such circumstances investors tend to be risk averse and so share prices are low and expected returns are high.
But this isn't the whole story. If we control for the dividend yield - a more direct indicator than unemployment of investors' risk aversion - then inflation is a powerful predictor of annual returns. Since 1989, on average, a one percentage point below-average inflation rate has been associated with five percentage points above-average real returns on shares in the following 12 months.
There's a simple reason for this. Inflation tends to feed on itself, with low inflation leading to low inflation and high to high. This is partly because low inflation causes people to expect low inflation in future, and such expectations are self-fulfilling, because people who expect low inflation don't raise prices or wages much. If inflation stays low, so too do interest rates. And shares tend to benefit from cheap money.
This poses the question: does the Bank of England's forward guidance overturn this relationship?
It would, if the markets believed the Bank's assurance that rates won't rise next year; if this were the case, then shares should be pricing in the benefits of sustained low rates. But markets don't believe the Bank. Futures markets are pricing in a quarter-point rise at the end of next year, even though the Bank thinks it unlikely that the threshold for a rate rise - sub-7 per cent unemployment - will be reached then. This suggests it's possible that the market will be surprised by interest rates staying low next year, which could be good for shares.
Perhaps, therefore, we should pay attention to the message of lower inflation - which points to better chances of the market doing well.
