In one sense, this correlation is odd. For a long time, inflation has been terrible for shares. Stock markets slumped in the 1970s as inflation took off, and soared in the 1980s as it fell. Why, then, do investors think inflation is a good thing now?
One possibility is that they think inflation is the least painful way of reducing the real debts of households, companies and governments, which would improve balance sheets and so enable faster growth in future.
This is unlikely to be the whole story, though. The correlation between inflation expectations and share prices was also positive between 2003 and 2007, when nobody much worried about debt or balance sheet recessions. Something else, then, is going on. There are at least two possibilities:
■ Inflation expectations are actually growth expectations; for example, inflation expectations fell in 2008 as investors feared a long and deep recession, and rose in 2009 as their worst fears dissipated. And higher growth expectations encourage 'risk on' trades.
■ Inflation expectations measure confidence in monetary policy. If investors expect monetary policy to be loose and effective, inflation expectations will rise. And this will be good for shares partly because of the expectation of faster real growth, but also because cheap money and plenty of it encourages speculation.
There are, therefore, good reasons for a strong correlation between share prices and inflation expectations. Equally, though, there's no guarantee the correlation will continue. Some forms of inflation, such as a rise in commodity prices due to an adverse supply shock, are bad for shares. And it could be that the correlation is only positive at the lowish levels of expected inflation we've had in recent years.
For now, though, the market likes the prospect of inflation. '“Sound money' is sometimes bad for equities.
