Why the Fed Loves the Stock Market Rally

Critics of the Federal Reserve’s stimulative stance often quip that supporting stock prices is the U.S. central bank’s unspoken third mandate, after full employment and stable inflation of 2 percent.

These claims have some merit, according to a paper co-written by Boston Fed President Eric Rosengren. But there’s good reason for the Fed to be happy about price appreciation in equities. If Americans feel wealthier, they’re more likely to increase their spending.

In that sense, a rise in stock prices constitutes an easing of financial conditions—a development of no small consequence for a central bank that’s been worried about how spillovers from market turmoil, of the kind seen last summer and at the start of 2016, could slow the U.S. economy.

In a note to clients, Bespoke Investment Group observes a particular benefit of the rebound in stocks since early February that probably comes as a relief to policymakers. The connection between changes in the SP 500 stock index and the “five-year, five-year breakeven inflation rate” has been strengthening.

The 5y5y inflation rate is thought to track what investors believe the average inflation rate will be over five years starting five years from now. It’s derived from the difference between yields on Treasuries and yields on Treasury Inflation-Protected Securities (TIPS). The chart below shows the increasingly firm link, recently, between the SP 500 and this gauge of inflation expectations.

“The beta (a measure of sensitivity) of five-year, five-year forwards to the SP 500 has moved up to 1.5x over the past few weeks,” Bespoke writes. “In other words, for every 1 percent the stock market moves, the five-year five-year tends to move 1.5 percent in the same direction.”

Falling oil prices and the rising U.S. dollar, largely two sides of the same coin, had served as dominant drivers of the breakeven inflation rate while it was declining, but the connection has been waning as these metrics move in opposite directions.

Bespoke, along with researchers at the San Francisco and St. Louis Federal Reserve Banks, has previously warned of the dangers of using market-based measures of inflation this way. But breakeven inflation forwards are clearly one of the metrics that matter to members of the Federal Open Market Committee and are therefore important to investors looking for clues to how the central bank feels about the progress it’s making in pursuing its dual mandate.

The recent increase in the rate should, all else equal, bolster policymakers’ faith that inflation, which has been weak, will return to the Fed’s 2 percent target. Conversely, the increasing connection shown in the chart suggests that any drop-off in stock prices would result in the 5y5y breakevens retreating in sympathy, according to Bespoke’s analysts.

“With that pullback, expect all sorts of scary charts about ‘falling inflation expectations,’ ” Bespoke concludes. “When you see them, breathe deep, and remember that financial market relationships are complex and easy to frame in terrifying ways!”

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