Expected Inflation and the P/E

The Fed implemented QE-2.0 to bring down the unemployment rate and to avert deflation by stimulating faster economic growth. As Fed Chairman Ben Bernanke acknowledged yesterday, the recovery is slow and “uneven.” Unemployment remains high. It’s not obvious that deflation was a clear and present danger late last year when QE-2.0 was implemented. Nevertheless, expected inflation in the 10-year TIPS yield rose from last year’s low of 1.49% on August 24 to a recent high of 2.64% on April 8. Since then, it dropped to 2.25% yesterday. The core CPI is up from 0.6% during October to 1.3% during April.

There’s good correlation between the S&P 500’s forward P/E and expected inflation in the 10-year TIPS yield. As noted above, expected inflation has dropped 39bps to 2.25% since April 8 through yesterday. The forward P/E dropped from 13.1 to 12.4 over this same period.