History tells us this should be good for equities simply because low inflation has usually been associated with high share valuations. Since current official consumer price inflation data began in 1989, the correlation between CPI inflation and the dividend yield on the All-Share index has been a hefty 0.72. For example, falling inflation in the 1990s was accompanied by falling dividend yields; rising inflation in 2000-03 saw dividend yields rise; and spikes in inflation in 2008 and 2011 were associated with rising yields.
The post-1989 relationship implies that a percentage point fall in inflation is associated with a 0.32 percentage point fall in the dividend yield - which is equivalent to a rise in the All-Share index of just over 10 per cent.
Lower inflation, then, is good for shares.
Or is it? There are two reasons to doubt whether this relationship will continue to hold.
One is that one reason why low inflation is normally good for equities is that it implies a looser monetary policy. But this might not be the case this time. Although economists expect interest rates to stay low for a long time - David Owen at Jefferies doesn't expect a rise until late next year - few expect any more quantitative easing. This, says Bristol University's Tony Yates, is odd, given how long the Bank expects inflation to be below its target.
A second reason for doubt is that the correlation between inflation and the dividend yield could break down at ultra-low levels of inflation. The lower inflation goes, the greater the chance of deflation - falling prices. The mere risk of this could be bad for equities either because it would reduce growth expectations - say, because deflation raises the real burden of debt - or simply because the prospect of something so unfamiliar would increase uncertainty.
On the other hand, though, there's hope that the correlation will remain positive. One big reason for it is that falling inflation has often been a sign of a positive supply shock - developments which allow both higher output and lower prices. And such a supply shock lies partly behind our present low inflation. The oil price has fallen by a third since July. And the long stagnation in labour productivity is over; latest figures show that total hours worked increased by 0.1 per cent in the third quarter, implying that GDP per worker-hour rose by 0.6 per cent - which is slightly above its long-term average.
In this sense, low inflation isn't due merely to weak demand in the euro area, but to more positive developments. And these should be good for shares.
