The Keynesian beauty contest continues. Here’s the takeaway from Wells Capital’s Jim Paulson latest on inflation expectations, with emphasis on expectations, and expectations based on those expectations:

For example, from Exhibit 2, in the deflationary-focused culture of recent years, the impact of money supply growth on the pace of economic growth has been significantly muted (indeed, an inverse relationship between money and economic growth has been commonplace) but its relationship to economic growth could quickly become significantly stronger again should cultural concerns shift away from deflation towards inflation. Indeed, how quickly could inflationary pressures suddenly surface, in an economy with an unprecedented level of excess bank reserves, should mindsets shift away from deflationary concerns?
Similarly, are stock investors prepared for how much the sand under their feet could suddenly shift? Not just from a mild rise in inflation expectations, but rather from a potential shift in mindsets from deflation to inflation concerns (i.e., a decline in the stock/bond correlation below zero). In the last year, the 10-year government bond yield has risen by almost 50% and yet the S&P 500 has increased by more than 20%. In a world dominated by deflation concerns, rising bond yields seem benign if not even friendly for the stock market. However, as shown in Exhibit 3, the seemingly harmless impact of recently rising bond yields could quickly turn more hostile for stocks. As Exhibit 3 implies, the impact of rising yields on the stock market may have less to do with how much they rise or how high they are, as it does with the surrounding attitude of investors concerning inflation/deflation as yields rise.

Double The Fun

Here’s my question. Since quantitative easing has never taken place before, the data from the past does not account for what turns out to be a new tool for the Fed: the potential sales of $3 trillion of assets which will in theory allow them to target the entire rate curve as well as the discount rate. (Nothing displayed below?)
[pdf width=”100%” height=”1100px”]https://s3.amazonaws.com/2014-WC-PDF/Wells.20140311-inflation-expectations-monitor.pdf[/pdf]
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