Central banks will have to keep an eye on inflation to the extent of restraining corporate earnings and market gains, says a CIBC World markets economist.

Inflation has been shrugged off by central bankers as they focus on fighting the growth slowdown, says Avery Shenfeld, CIBC World Markets’ senior economist. “But equity investors shouldn’t be so quick to conclude that inflation doesn’t matter anymore. For behind the benign core CPI headlines, there is growing evidence that a return to the glorious world of 4% real growth in North America, what stock markets are increasingly counting on for next year, might not be consistent with stable inflation rates.”

Shenfeld says that the only reason inflation is subdued right now is because the emergence of the manufacturing recession, which has brought on aggressive price cutting. “But drastic price cuts and margin compression would surely come to an end if the manufacturing sector saw the sort of rebound that investors anticipate. Without that counterweight, there would be nothing to mask other sources of upward pressure on core prices. Moreover, a rebound to brisk global growth would only amplify the recent strains on energy sector supply.”

Central bankers will have to find that fine line between stimulating growth and sparking inflation, he suggests. “It might mean that the Fed ends up welcoming an extended period of growth in the 2-2.5% range, and a jobless rate closer to 5% than 4%, as a means of protecting against a real inflation problem. The Bank of Canada has been more explicit on that score, still warning that the economy would bump up against its non-inflationary limits if growth soon returned to its former vigor.”

Shenfeld concludes that, “Equity investors still have reasons to view the threat of inflation as a cap on next year1s sales and earnings growth.”