stock questions: #4

Q:  Am I (as a stock holder) supposed to be rooting for good economic news, or bad economic news?  It seems every time there is bad economic news stocks go down because everyone is worried about a recession.  But if there is good economic news, stocks often also go down as the market worries the Fed will have to keep jacking up interest rates to cool the economy and inflation.  Is there a goldilocks zone somewhere?

The short answer is that we should be rooting for good economic news. The deeper question is what’s good and what’s bad. It doesn’t help matters that the factors influencing the US economy at the moment are particularly complex.

The right way to start looking for answers, I think, is to understand what the economic aims of the country–and therefore of government economic policy–are in the US.

US economic goals, in theory anyway

The most important Federal economic goal is to achieve maximum sustainable GDP growth while keeping inflation under control. Early in my working career, “under control” was the dream of a steady 4% annual rise in prices. Most recently, the target has been set, by academic theory, at 2%. There’s serious discussion that the right number for today is 3%, the thought being that 2% is too close to zero and in particular that when the Fed has tried to boost inflation above (the too low) 1.8%-ish, where it had been for a half-decade or so, it wasn’t able to make prices budge. For what it’s worth, I’m in the 3% camp.

In advanced economies, inflation (i.e., steady, year-after-year increase in the price level) is ultimately wage inflation. The tool most often used to keep it in check is monetary policy.

(A long aside: This strategy is based on experience that shows Congress drags its feet so much that its help is often too late to do any good. You may remember that the Republican position during the 2008-09 financial crisis was that it would be better to have a repeat of the Great Depression (a decade of economic contraction, world GDP down by 15%, 20%+ unemployment in the US, widespread bankruptcies…) than bail out the banks for what seems to me to have been outright fraud in the home mortgage market. A gigantic fall in stock prices the following day changed their minds. Even so, the package that came out of Congress, while better than nothing, was maybe a third of what was needed to heal the domestic economy. Monetary policy and the passage of time did the heavy lifting, instead. No stomach in Washington for prosecution of the main offenders, either.)

The Fed raises rates to cool the economy down when it’s overheating (meaning growing fast enough to create inflation, and with no signs of slowing down) and lowers them to speed economic activity up when it stumbles. In my 40+ years of watching this process, the monetary authority always overshoots in both directions. It never intends to, but there are significant data lags in economic indicators and the Fed always wants to be sure.

where we are now

We’re in a post-pandemic, post-pandemic-denial, phase now where both the shockingly timely fiscal stimulus and the monetary stimulus from lowering interest rates to zero are being withdrawn. The fiscal stimulus is already in the rear view mirror; the “shock” of its absence, if that’s the right word, is being cushioned by the government payments in consumers’ hands but not yet spent.

The increase in interest rates back to “normal” is still under way. We can try to figure out what will happen from here in the way the Fed usually does–by looking at how much of the workforce is employed, what wage gains are and what the current level of interest rates is vs. our best guess at what a neutral rate is (neutral = not inflationary, but not causing the economy to slow). The last of these is arguably the most important.

the target rate

There’s no reason to buy a government bond if the interest rate doesn’t even cover the loss of purchasing power caused by inflation. Let’s say that investors expect inflation protection + a 1% real yield. Let’s also assume that supply chain disruptions are more or less straightened out by yearend (I’m not saying they will be, I’m saying suppose) and that commodities like oil and some semiconductors neither rise in price nor fall next year (I’m in the fall camp, but don’t want to bet the farm on this). If so, the 10-year Treasury note should be trading at a yield of: inflation + 1%. Let’s say: 2.5% – 3.0% + 1% = 3.5% – 4.0%.

The Fed has raised the Fed Funds rate from basically zero to 1.5 – 1.75%, moving the 10-year to 3.5% a few weeks ago. Another 0.75% hike appears to be on the cards for late this month.

If my back of the envelope calculation two paragraphs above is anywhere near to correct, we’re very close to where interest rates should be, at least for a plain vanilla economic cycle. It may be that the Fed will feel the need to cool the labor market down by raising rates a bit further. But my guess is that, if so, it will reverse course once it’s clear that the level of wage increases has stabilized.

Of course, this isn’t a plain-vanilla cycle. The pandemic, the war in Ukraine and the bizarre economic policies of the Trump administration all qualify in my mind as external shocks. More tomorrow.

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