On Wall Street, the combination of moderate economic growth and very low inflation is commonly called the “Goldilocks economy,” after the fairy tale about a girl who wants her porridge “not too hot and not too cold.” But a crucial feature of the Goldilocks economy is widely misunderstood by investors, economists, and even central bankers: the apparent contradiction between high stock prices, which seem to anticipate strong economic activity, and falling bond yields, which seem to predict global recession or secular stagnation.
Most economists seem to believe that stock markets are over-optimistic and wrong, while bond markets “know something” troublesome about the future and are right. Others argue the opposite. But what both sides miss is that, in a world of persistently moderate growth and persistently low inflation, seemingly optimistic stock markets and seemingly pessimistic bond markets is no contradiction. Sky-high equity prices and rock-bottom bond yields are simply sending messages about totally different subjects.
Equity prices are driven by prospects for real economic activity and the expected corporate profits that will result from it. But bond prices are driven by the prospects for inflation and the expected interest rates that will result from it. In the pre-crisis world, strong economic growth almost invariably meant higher inflation and, therefore, higher interest rates. But during the past decade, the links between economic activity, inflation, and monetary policy that were taken for granted in the 1980s and 1990s have completely broken down. The pre-crisis dogma that inflation “is always and everywhere a monetary phenomenon” has turned out to be nonsense, at least for advanced economies, where central banks have printed money like wallpaper without any inflationary response.
The breakdown of old links between growth and inflation could be due to globalization, technology, demographics, the weakening of organized labor, or other reasons. But whatever the causes, the consequences for financial markets should now be clear. Until the combination of steady growth and low inflation is seriously disrupted, asset prices will remain much higher and bond yields much lower than pre-crisis analysis considered normal. Sooner or later, some political shock will doubtless disrupt the happy balance of robust global growth and low inflation, as US President Donald Trump’s trade wars and oil sanctions almost did last year. But until such a shock actually happens, investors can sit back and enjoy their porridge just the way they like it.
Anatole Kaletsky is chief economist and co-chairman of Gavekal Dragonomics. A former columnist at the Times of London, the International New York Times and the Financial Times, he is the author of "Capitalism 4.0, The Birth of a New Economy," which anticipated many of the post-crisis transformations of the global economy.