[jyl]

The inflation genie periodically arises here. I don’t know if inflation is headed higher or lower, but the Fed is trying to push inflation up and has just raised its target from 2% to something above 2%.

Classically, the theory is that higher inflation led to higher interest rates which lowered valuation multiples. (Whose theory? Well, mine, although I read it somewhere.)

Look at the present value formula V = C / ( r – g ) where V is present value, C is present cashflow, r is interest rate, g is growth rate of future cashflow. Higher interest rate increases r. Higher inflation may or may not increase g. Inflation increases both sales and expenses, how much for each – and thus whether cashflow increases – varies by industry. For the S&P 500 overall, g increases less than r. So r – g increases, and V declines. C is fixed, being today’s cashflow. So V / C declines, and that is your valuation multiple.

The real world is too messy and aberrant to closely fit such a simplistic formula, but I think that helps with thinking about directional changes.

As for why higher inflation leads to higher interest rates, classically if investors expect a future dollar to buy fewer goods, services, and labor on Main St, they demand more of those future dollars on Wall St. This is a link between the real economy and the financial economy.

What happens if you break that classical relationships, and higher inflation does not lead to higher interest rates? Sever real and financial economies by applying some force to hold rates constant regardless of inflation.

Now r is constant but g increases, r – g decreases, V rises, V / C rises, and valuation multiples rise.

Central banks have learned how to push down on rates, by buying bonds (QE). The Fed has the buying power to move any market, even the bond market.

Goverments have always known how to push up on inflation, by spending.

The disconnect between the real economy and the financial economy widens.