"Inflation Expectations Are Falling; Run for Cover" http://uneasymoney.com/2012/05/14/inflation-expectations-are-falling-run-for-cover/ 14 May 2012 "The S&P 500 fell today by more than 1 percent, continuing the downward trend began last month when the euro crisis, thought by some commentators to have been surmounted last November thanks to the consummate statesmanship of Mrs. Merkel, resurfaced once again, even more acute than in previous episodes. The S&P 500, having reached a post-crisis high of 1419.04 on April 2, a 10% increase since the end of 2011, closed today at 1338.35, almost 8% below its April 2nd peak. "What accounts for the drop in the stock market since April 2? Well, as I have explained previously on this blog (here, here, here) and in my paper âThe Fisher Effect under Deflationary Expectations,â when expected yield on holding cash is greater or even close to the expected yield on real capital, there is insufficient incentive for business to invest in real capital and for households to purchase consumer durables. Real interest rates have been consistently negative since early 2008, except in periods of acute financial distress (e.g., October 2008 to March 2009) when real interest rates, reflecting not the yield on capital, but a dearth of liquidity, were abnormally high. Thus, unless expected inflation is high enough to discourage hoarding, holding money becomes more attractive than investing in real capital. That is why ever since 2008, movements in stock prices have been positively correlated with expected inflation, a correlation neither implied by conventional models of stock-market valuation nor evident in the data under normal conditions. "As the euro crisis has worsened, the dollar has been appreciating relative to the euro, dampening expectations for US inflation, which have anyway been receding after last yearâs temporary supply-driven uptick, and after the ambiguous signals about monetary policy emanating from Chairman Bernanke and the FOMC. The correspondence between inflation expectations, as reflected in the breakeven spread between the 10-year fixed maturity Treasury note and 10-year fixed maturity TIPS, and the S&P 500 is strikingly evident in the chart below showing the relative movements in inflation expectations and the S&P 500 (both normalized to 1.0 at the start of 2012. <img src="http://uneasymoney.files.wordpress.com/2012/05/sp500_inflation_2012.jpg?w=500&h=375"> "With the euro crisis showing no signs of movement toward a satisfactory resolution, with news from China also indicating a deteriorating economy and possible deflation, the Fedâs current ineffectual monetary policy will not prevent a further slowing of inflation and a further perpetuation of our national agony. If inflation and expected inflation keep falling, the hopeful signs of recovery that we saw during the winter and early spring will, once again, turn out to have been nothing more than a mirage."