QE2 and Operation Twist were announced after market drops. And the recent swoon in the Dow, despite rebounding yesterday, along with some rather weak economic data, have reignited new speculation that Bernanke & Co. might finally announce a new stimulus program. That’s led some critics to contend that Bernanke cares more about the direction of stocks than the general economy. Others, who predict the Fed’s moves will spark massive inflation, say Bernanke is choosing investors over consumers.

But a new study suggests that keeping an eye on the market is exactly what Bernanke should be doing.
Inflation Tracking Portfolios
, which was released as a working paper by the NBER this week, looked at the movement in consumer prices and a number of various investments from the beginning of 1985 through the end of last year. The study’s authors, which included UCLA economics professor Francis A. Longstaff and two employees from investment firm Blackrock, found that most things that we generally tend to think of as inflation hedges, such as gold and real estate, tend to overstate the actual moves in prices. Even Inflation-Protected Treasury bonds, nicknamed TIPs, came out as a pretty poor predictor of future inflation. Prices of TIPs tended to jump around much more than overall prices did. The best inflation oracle: the market.

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In general, the authors found that future inflation tends to track stocks better than anything else they looked at. So if the market dropped over the course of a month, it tends to indicate that inflation will be lower a month from now. A jump in stocks, tends to mean consumer prices will rise as well.

What’s more, the authors found some industries are more correlated to inflation than others. Oil stocks tend to move in the same direction as inflation; retail stocks, not as much. So if you really want to track inflation, you need to build a portfolio that long the sectors that are correlated with inflation and short the sectors that are not, which is what the authors of the study did. What is the inflation portfolio predicting now? Generally, that inflation, which dropped 0.3% in May, will continue to fall. The authors stopped constructing their portfolio at the end of 2011. But oil stocks are down 14% in the past month. A number of retailing stocks, on the other handing including Wal-Mart (WMT) and Target (TGT) are up. Sears (SHLD) is down.

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Longstaff says he wasn’t looking to make any statement about monetary policy. But if stocks are really the best indicator of future inflation, then it seems to make sense that Bernanke would jump to action, as he has, when stocks have dropped. And given how bad May was, another QE or some other round of Fed stimulus is probably on its way, or at least it should be.