Two friends catching up in a coffee shop got into an interesting conversation as Bruce Springsteen’s ‘easy money’ started playing.

Ram: With Fed Governor acknowledging inflation is not transitory, is the era of easy money which has underpinned the stock market rally coming to an end ?

Veena: It may be the case in 2022, although there are divergent views.Some economists are saying inflation will be persistent and will require stronger monetary actions, while some believe inflation will subside once supply chain disruptions are sorted out and central banks should not overreact.

Ram: Why are economists confused and giving contradictory view points?

Veena: Yes, the reason for that is that the drivers of inflation have three main components – demand pull, cost push and inflation expectations. It is not just about demand and supply alone, but also..

Ram: I understand the first two, what is this inflation expectations?

Veena: It’s about the expectations people have about inflation. The behavioural aspect that can influence prices. It is like the FOMO (fear of missing out) in stock markets when prices keep going up and at some stage may get disconnected from fundamentals. People jump in to buy stocks when they believe it will go up and don’t want to miss the opportunity. Same way if people expect inflation to go up they may start advancing their purchases out of expectation that they will have to pay more for it later if they defer their buying decision. They may even start hoarding. Companies will be able to pass on price increases as people are buying more, and at some stage workers will demand higher wages as well due to inflation and company’s ability to pass on higher prices. So it becomes a spiral where inflation feeds on itself.

Ram: Oh okay, interesting.. So, interpreting data on demand and supply apart, economists also need to factor the behavioural component which is not easy to model or predict.

Veena: Exactly. For example in the 1970s decade of stagflation in the US, it went through a long phase of low economic growth and even recession while at the same enduring high inflation. The inflation then, besides easy money policy of the Fed early in the decade and subsequent supply shocks, was also driven by the important factor of inflation expectations. People had got accustomed to believing prices of goods and services will keep going up and it would be better to buy early. The inflation expectations was broken with what is known as the ‘Volcker shock’. In 1980 he increased the Fed funds rate to 20 per cent. For comparison the current Fed funds target rate under Jerome Powell is at 0-0.25 per cent. The Volcker shock worked. Although it caused a recession, it finally changed people’s inflation expectations to believing that price rise will be under control.

Ram: So the action of Central Banks will be a key determinant of inflation expectations.

Veena: Yes. Their policies, actions, communication all play a part in this and beyond views on prices of goods and services, it will also influence people’s expectation for interest rates, stock valuations etc.

Ram: So if investors believe Central Banks can keep inflation under check, they will overlook short bouts of inflation and remain positive on equities.

Veena: Bingo! And vice-versa as well. So watch out for not just inflation in 2022, but also inflation expectations. If you recollect, the period of sub-par stock market returns in India between 2010-13 coincided with periods of high inflation and high inflation expectations.

Tune in to the Portfolio Podcast on the topic here .


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