Market Ethos - February 20th, 2018

Expectations Are Inflating


The U.S. Federal Reserve has a dual mandate of targeting 2% inflation and maximum employment. They are doing a great job of achieving their employment goal with only 4.1% of Americans looking for a job and not being able to find one. However, targeting 2% inflation has been elusive. Stephen Poloz and the Bank of Canada have half as much to worry about as they only target inflation. Up until recently, fears have been of deflation (where aggregate prices trend lower). Sentiment has pivoted lately with U.S. wage growth accelerating quicker than expected (Feb. 2) and inflation exceeding expectations (Feb. 14). Some even blame the recent market sell-off on this concern over inflation, which would lead many to think inflation is a bad thing. That is not necessarily the case, as moderate inflation can be beneficial to the economy.


The reason why this moderate increase in aggregate prices is viewed with caution is because if inflation moves above and beyond the FED’s target their best tool for reining it in is by hiking short term rates. A rapid increase in rates makes it more expensive to borrow, disincentivizing companies to invest and hire. It lowers the future value of cash flows (a higher discount rate lowers the present value of future earnings) which is negative for equities because the multiple paid for those cash flows will be lower, which decreases the price investors are willing to pay for a stock. And of course higher short term rates is negative for bonds.