Anirvan Banerji in notes that the predominant economic risk at the moment is inflation and not recession. The Economic Cycle Research Institute’s Future Inflation Gauge (FIG) stands at a five year high.

The FIG is a well-established indicator that combines a number of factors into a single measure that has done a good job of predicting future inflation. In contrast many commentators are downplaying the risk of inflation by focusing on the quiescent core-CPI numbers. Banerji believes that the FIG model will prevail with inflation pressures continuing into 2006.

Indeed higher inflation could put a damper on stock prices. Jon Markman in highlights some research by Ned Davis Research that shows inflation has a more significant effect on equity returns than does earnings growth.

There do seem to be some better clues as to future market direction. Consumer-price inflation may be at the top of the list. Davis researchers report that in the 49% of the years when inflation has been clocked at greater than 3.5%, stock-market returns have been subpar, at 3.9% per year. When inflation has been less than 3.5%, returns have bulled forward at a 9.8% annual pace.

Moreover, in periods like the present, when the price of food and energy is the main driver of Consumer Price Index inflation, the Dow Jones industrials have risen just 2.7% a year since 1958. That contrasts with 11% gains when inflation is not driven by energy and food.

The bottom line, according to the researchers, is that lower inflation, not higher earnings, may be the key to future stock returns. If the relationship holds up, therefore, investors should be less jubilant about the potential for solid returns in 2006 based simply on the prospect for continued earnings gains, and instead root for the Federal Reserve’s efforts — sadly ineffective, so far — to quell the past year’s surge in inflation.

Inflation has a pervasive effect on the capital markets, undermining the value of all nominal assets. If the FIG model is correct then inflation will continue to dampen equity values for some time to come.