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Despite what you may have heard, the rising threat of inflation is not the reason for the stock market's slide. It's the excuse. Furthermore, it's the wrong excuse.

Yes, inflation fears are getting the lion's share of the blame for the tailspin in global equity markets over the past few days, centred on the U.S. market. The U.S. benchmark Dow Jones industrial average shed nearly 2,300 points, or nearly 9 per cent, in a little over a week – most of it coming last Friday and Monday. (Stocks had a bounce-back day Tuesday, recovering more than 500 points of those losses. If you're prone to motion sickness, you might want to put your head between your knees for the rest of the week.)

The story has been that the selling frenzy was set off by a U.S. employment report that showed a spike in wage inflation, clocking in at its highest year-over-year pace since 2009. Now, we hear, the markets are worried that the U.S. Federal Reserve has badly underestimated inflationary pressures coming from the long-booming U.S. labour market, which it let run too hot for too long through its years of low-interest-rate policy. That suggests the Fed is behind the curve on raising interest rates to tame inflation, and will have to pick up the pace in the coming months – which would slam the brakes on stock values and the economy.

But central banks, in the United States and elsewhere, haven't been caught flat-footed by inflation. The stock markets have.

The Fed has been raising interest rates for more than a year, even though the U.S. core personal consumption expenditure (PCE) inflation – the Fed's key gauge of underlying pressures – has been waffling around 1.5 per cent, still well below the Fed's 2-per-cent inflation objective. It has done this based on its faith that the tight U.S. labour market – where the unemployment rate is at a 17-year low – would eventually spur inflation, the conspicuously missing ingredient in the world's post-crisis economic recovery.

(Similarly, the Bank of Canada has been raising interest rates since last July, even though the central bank's preferred measures for core inflation took a meaningful turn upward only in the past couple of months.)

In its latest quarterly economic and rate projections, released in mid-December, the Fed openly told the markets that the members of its rate-setting Federal Open Market Committee anticipated three quarter-point interest-rate hikes this year. The Fed's tweaking of its language around inflation in last week's interest-rate decision, in which it decided to hold rates steady for the time being, suggested that there was some upside risk to that projection.

Yet, when the year began, the financial markets were only pricing in two rate hikes. Even now, amid this supposed sudden awakening to inflation risks, the markets have still only inched into three-hike territory.

And while the bond market started to grasp the inflation story around the time of the Fed's mid-December rate hike, with break-even inflation rates in real-return bonds creeping higher ever since, the equity market seemed intent on continuing to turn a blind eye.

Only now, after having stormed ahead by 8 per cent in the first four weeks of the year on little more than the market's own hot air, did traders decide en masse to take notice. Inflation serves as a convenient scapegoat for a correction in stocks that was desperately overdue.

Before the selloff, the Dow had risen a dizzying 6,500 points in the previous 12 months, setting record high after record high. That's a 32-per-cent gain, over a period in which the global economy grew an estimated 3.7 per cent, the U.S. economy grew 2.3 per cent, and corporate earnings on the S&P 500 rose by about 12 per cent. Price-to-earnings ratios, a key gauge of stocks' value, had swelled to 50 per cent higher than their 10-year average.

Anyone with even a tenuous grip on reality could tell that this rally was a teetering tower of wild-eyed optimism just waiting to topple; all it needed was a plausible catalyst. The wage-inflation numbers showed up right on cue. "Hey, we didn't overdo it; the Fed gave us a massive head-fake on inflation and rates," came the moan over the repeated clicking of "sell" buttons.

Thing is, it's not even clear that the U.S. January wage numbers signal what the markets have decided they signal. Bank of Nova Scotia economist Derek Holt noted that the unexpected surge in wage growth in January was based on seasonally adjusted figures, which are pretty irrelevant when looking at year-over-year growth; on an unadjusted basis, without the seasonal adjustment, year-over-year wage growth actually slowed from December. The apparent building wage pressures may be more a quirk of seasonal adjustments than the game-changing trend they've been blown up to be.

That's not to say the stock market doesn't still have some work to do. Even without a shift in the inflation outlook, the market has some catching up to do to capture the likely reality of interest rates over the next 12 months.

But if the market really needed a reason to worry more about interest-rate risk, it overlooked what may prove to have been a more compelling moment: when the Trump administration's tax plan went through in late December. The tax cuts will stimulate an economy that, it's increasingly apparent, doesn't need it. If you think overstimulation is a good thing, try taking a toddler who has been eating candy all day, and give him a shot of espresso.

The Fed has a tried and true method to calm that hopped-up toddler: higher interest rates. If the stock market wants to reprice rate-hike risk, it ought to consider how hard the Fed might need to lean against the Trump fiscal stimulus to keep the economy calm.

U.S. stocks rose two per cent Tuesday after swinging sharply between gains and losses throughout the session as Wall Street tries to end a global stock market plunge that has erased $4-trillion in global equity wealth.


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