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This column appeared January 23rd, 2018 at the Foundation for Economic Education.
The stock market was a wild ride in December. At one point, it was on track for its worst December since the Great Depression. Many observers saw in this the first twitchings of an economic downturn. They may well be right. Or, they may not.
In 2007, the subprime mortgage bubble burst. The Federal Reserve acted as it had when the dot-com bubble burst in 2000 and slashed the federal funds rate. It fell from 5.25 percent in September 2007 to 0-0.25 percent in December 2008, and it stayed there for another seven years.
But conventional monetary policy was not enough. So serious was the downturn and so ravaged were the balance sheets of financial institutions that unconventional measures were called for. The Fed began printing money and using that to buy assets from financial institutions, providing them with desperately needed liquidity. Prior to the start of the recession in 2008, the US Federal Reserve System held between $700 billion and $800 billion of Treasury notes on its balance sheet. In November 2008, the Federal Reserve began purchases of $600 billion in mortgage-backed securities. By March 2009, it held $1.75 trillion of bank debt, mortgage-backed securities, and Treasury notes. By June 2010, this had swelled even further to a peak of $2.1 trillion.
This vast infusion of liquidity did little apparent good for the “real” economy. Between March 2009 and October 2018, US GDP rose by 23 percent, in real terms. But it was a boon to the stock market. With low margin costs for trading stocks, it enabled investors to speculate cheaply in assets, and it made it cheaper to borrow to fund share buybacks, dividend increases, and mergers and acquisitions. As a result, between March 9, 2009, and October 2, 2018, the S&P 500 rose by 332 percent. Wall Street surged ahead of Main Street.
But that wasn’t the worst of it. It wasn’t just that the Federal Reserve’s monetary policy was doing little for the “real” economy. Soon, the interests of Wall Street and Main Street were at odds.
In December 2013, I wrote the following in the Wall Street Journal:
On Aug. 15, the London Telegraph reported that British retail sales had risen unexpectedly sharply and that American unemployment had fallen to a six-year low. This would usually be promising macroeconomic news, but that day major indexes—the Dow Jones Industrial Index, the S&P 500, the CAC 40, among others—tumbled. Markets, hooked on the Fed’s cheap liquidity cocktail, were terrified that an improving U.S. economy might see the punch bowl removed with a Fed “taper” of quantitative easing [QE].
A day later, when the results of a U.S. consumer confidence survey came in “far worse than expected,” stock markets rallied.
This divergence between the fortunes of the stock market and those of the “real” economy continued. In 2016, the BBC reported: “Wall Street boosted by weak US GDP data.” It explained:
US stocks opened higher after weak GDP data raised expectations that the US Federal Reserve would go slow on future interest rate hikes.
The Fed had printed itself into a corner. With QE and a low funds rate it had stoked a stock market boom. But if the “real” economy strengthened, these policies would be reversed; QE would be unwound, and the funds’ rate would rise. What, then, would happen to the stock market? Any sign of a strengthening economy sent shivers through the stock market.
It may well have been the worst recovery since World War II, but eventually, the US economy got going again. And that meant higher interest rates and an end to QE.
Monthly inflation averaged 0.12 percent in 2015. In 2016, this had risen to 1.26 percent and 2.13 percent and 2.49 percent in 2017 and 2018, respectively. As inflation rose, so did the fed funds rate. Since December 2015, this has risen from the 0-0.25 percent target, which prevailed for the previous seven years, to a current rate of 2.25-2.50 percent—not high by historical standards but higher than at any time since March 2008.
The tighter monetary policy, which many stock investors had feared, had arrived. And the effect was, perhaps, predictable. A boom built on loose monetary policy was always likely to splutter when that policy tightened.
It is important to note that this had to happen at some point. When—if—the economy strengthened, monetary policy would be bound to “normalize.” This would imperil the stock market boom. The question was whether this normalization could be accomplished without tanking the “real” economy again.
A commonly watched monetary measure, the yield curve, has been flashing red recently. It should generally rise from left to right, with lower yields for short-term Treasury bonds than long-term ones. Recently, the curve has flattened and may be on its way to inverting. Bad economic things often follow.
But at the same time the stock market was cratering, the “real” economy chugged along. A survey conducted in November in my home state, Minnesota, found the state’s manufacturers reported they expect a solid 2019. The December jobs report showed non-farm employment was up by 312,000, a figure that left many observers searching their thesaurus for synonyms for “blockbuster.” On December 21, Macroeconomic Advisers boosted their fourth-quarter estimate of GDP growth to 2.8 percent. The data here are not yet confirming the slowdown the markets see.
A word of caution: We know a lot less than we don’t know. In October 1929, the economist Irving Fisher proclaimed that “stock prices have reached ‘what looks like a permanently high plateau.’” The next month the stock market collapsed so far and so fast that the ticker tape in the New York Stock Exchange couldn’t keep up with the falling prices. I wouldn’t be as bold as Fisher.
But, ultimately, stock markets are supposed to be driven by the expectations of a stock’s perceived profitability, not the pursuit of speculative gains caused by the manipulations of central bankers. For too long, the economy has been in a position where the interests of financial markets are precisely at odds with the interests of the rest of the economy. This has to end. If December’s gyrations are the worst we have to deal with while it does, we will have gotten off lightly.