Warsh's Dovish Leanings: A Boon for Stocks in a Hot Economy

The recent market debate surrounding Kevin Warsh's potential policies as the new Fed chair has sparked concerns about inflation and its impact on stocks. However, a closer look at history suggests that when the Fed allows inflation to run hot, equities tend to perform well.

In 2021, Mike Wilson noted that corporates operate in the nominal world and can benefit from higher input costs if consumers are willing to pay more. As long as households can't discern whether a price hike is 'excessive,' inflation can be a revenue boon for companies. This was evident during the pandemic year when many firms raised prices above necessary levels, resulting in record-high margins that haven't receded since.

The tight correlation between corporate revenue growth and producer price growth supports this notion. As Wilson said, 'As with most inflationary cycles, the danger for equities typically emerges when the Fed becomes overly restrictive in response to pricing pressures, not when it allows inflation and growth to run hotter for longer.'

In fact, Wilson predicts that the Warsh Fed will err on the dovish side this year, similar to the Powell Fed in 2021. This could be good news for stocks until the inflation situation becomes untenable, at which point a reverse wealth effect may be necessary to control inflation.