Blog - Investing Notes

January 20, 2007 - Core vs. Total Inflation in the REY Model

How would the projection of the short-term version of the Real Earnings Yield (REY) model change if we used core inflation rather than total inflation as an input? In our blog entries of 7/6/06 and 12/15/06, we concluded that total inflation is a marginally better indicator for overall stock market movements than core inflation (more noticeably over the long term). We have since modified the model, so here we revisit the statistics for core versus total inflation and compare the REY Model outputs that they generate. We find that...

The following chart shows the behavior of the actual S&P 500 index along with current backtests/projections for the short-term version (using data for 2004-present) of the REY model from both a total inflation input and a core inflation input. For both inflation inputs, we use the inflation forecasting method described in the Inflation Forecast section. Since the method is empirical, it might inherently favor total inflation.

The Pearson correlations between the actual S&P 500 index and the modeled stock market are 87.9% for core inflation and 93.7% for total inflation. Total inflation better indicates the direction of the stock market.

The standard deviations of differences between the actual S&P 500 index and the modeled stock market are 3.9% for core inflation and 6.5% for total inflation. Core inflation better indicates the level of the stock market. The chart shows that this advantage for core inflation will widen unless stocks advance quickly and substantially.

The long-term version (using data for 1990-present) of the REY model still gives the nod to total inflation. For this version, the Pearson correlations between the actual S&P 500 index and the modeled stock market are 87.4% for core inflation and 88.8% for total inflation. The standard deviations of differences between the actual S&P 500 index and the modeled stock market are 17.5% for core inflation and 15.8% for total inflation.

It is plausible that the Federal Reserve Board is focusing investors/traders more than usual on inflation in general and core inflation in particular. Core and total inflation converge as often as they diverge, but unless crude oil prices recover from their recent sharp decline, it seems likely that these inflation measures will move further apart in the next couple of months.