A common argument against stocks rising this year is that the Fed is afraid of market rallies. The thinking goes like this: a rising stock market could reignite inflation, something the Fed does not want. Therefore, the Fed will work to keep a lid on market rallies until they are certain inflation has returned to a sustainable target of 2%.
Where did the argument come from?
There’s just one problem with this argument: the historical evidence doesn’t support the idea that market rallies spur inflation. In looking at periods of strong stock market rallies, such as the 1990s and 2010s, inflation remained subdued even as markets soared.
Before examining the relationship between inflation and rising stock prices though, let’s look at how the argument came to form; where did the consensus that the Fed does not want stocks to rally come from?
It all started last April
The belief that the Fed wants lower stock prices gained momentum in April of last year when markets were still within 6% of all time highs. That’s when Bill Dudley, a former member of the Fed, wrote an op-ed on the key’s to the Fed’s fight against inflation. “To be effective, (the Fed) will have to inflict more losses on stock and bond investors than it has so far.” Mr. Dudley said.
Mr. Dudley’s words were viewed as a mouthpiece for the Fed. His op-ed sparked a market sell-off that resulted in the worst monthly decline since 2008. The pullback continued into June before stocks started a summer rebound. Stocks would rally nearly 20% from their June lows into August.
Ahead of a key speech by Federal Reserve Chairman Jay Powell that August, the Wall Street Journal reported that there was concern at the Fed over the market’s rally.
According to Nick Timiraos of the Journal, “Fed officials thought investors were misreading their intentions given the need to slow the economy to combat high inflation.”
Mr. Powell then delivered a headline grabbing message to markets in that August speech, noting that the Fed’s fight against inflation will involve “some pain.”
Most recently, in minutes released from the Fed’s meeting in December, some Fed members noted that, “an unwarranted easing in financial conditions” could make their fight against inflation harder.
All of these communications have influenced the consensus opinion that the Fed does not want stocks to rally.
But do rallying markets cause inflation spikes?
But what does the data actually say: do rallying stock markets cause inflation to spike? To find out, we looked at yearly returns for the S&P 500 since 1926 matched with yearly CPI data. We then grouped market returns into various categories from very negative to very positive.
Based on the consensus, we felt the data should show that when markets are up big (think 20% or more in a year), inflation should also be up a lot. Or, if inflation wasn’t up that year, it should certainly spike in the following year, since rising markets spur inflation… right?
In fact, when markets were up the most, yearly inflation was quite tame.
Ironically, inflation has spiked more frequently following modest declines in stocks compared to big gains. The graph below shows higher inflation in the year after a 5-10% decline for stocks compared to the years after gains of 20% or more.
In addition, the percent of the time that next year’s inflation spiked above 6%, has been higher in the year after a negative market return than a positive one.
Even if we lower the threshold to a more modest inflation spike of just 4%, we see the same thing: current and next year’s inflation has spiked more frequently alongside of, and following, a declining stock market compared to one that experiences big gains.
Based on our findings, one might argue that the Fed should be more fearful of negative market returns than positive ones. The only thing we’re sure of when we look at the data is the following:
- Market returns are very random
- Inflation seems to be quite random in relation to market returns
- There’s no clear link between big market gains spurring inflation
So what about the Fed’s fear?
So if there isn’t a link between big market gains spurring inflation, is the Fed’s fear misplaced? Well, on that topic we’d say we’ve never officially heard Mr. Powell say he doesn’t want stocks to go up. If he was presented with three options: stocks rising, stocks falling, or stocks doing nothing, we guess he’d probably prefer for stocks to do nothing. But that’s not the same thing as him wishing they’d fall.
In fact, he had a great chance to move the market lower last week when he was asked specifically about the market’s gains to start the year: Instead, Mr. Powell pointed to the good work the Fed has already done, mentioning that financial conditions have, “tightened very significantly over the past year.” And that he’s not focused on “short-term moves.”
This suggests to us that the narrative around the Fed wanting lower stock prices is much more media driven than anything else. The data doesn’t support the argument and Mr. Powell doesn’t appear to explicitly support the argument either.
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