Is the Economy Doing Too Well?

Is there such a thing as too much good economic news? That sounds counterintuitive. After all, don’t we want low unemployment, high corporate earnings, and strong real estate and stock markets? Of course we do. However, when it comes to the economy, too much success leads to inflation. Inflation is bad (an oversimplification, but let’s just go with it for now).

The recent volatility in the stock market was not due to concern that the economy is slowing down. Quite the opposite. The fear is that tax cuts, deregulation, and increased government spending are going to overheat the economy and lead to high inflation.

If you get this point, you will understand economics:

The Federal Reserve has two goals:

1) Keep inflation around 2%.

2) Keep the labor market at “full employment.”

Full employment is the lowest unemployment rate that does not cause inflation. That rate was thought to be a jobless rate of about 5 percent. Currently, unemployment is only 4.1 percent, which is leading many to conclude that employers will have to raise wages and companies will have to raise prices.

The Fed raises interest rates when it wants to cool off the economy. The problem is it takes a long time before you know whether interest rate adjustments are working. Imagine you are trying to adjust the temperature in your shower, but it takes 6-18 months for your adjustment to be felt. After a few months, when the water is not getting warmer, you adjust some more, and some more, and then you find out that you over-corrected and the water is scalding. This is the Fed’s predicament. If it over-corrects, it could cause a recession.

How do Trump and Congress affect the economy?

The Federal government (President and Congress) has no control over interest rates. Instead, it uses tax policy and government spending to influence the economy. Both tools take a long time to change and a while to kick in. Think of the economy as a supertanker…you have to plan in advance if you want to turn this thing around.

Congress recently enacted major tax cuts, voted to increase spending, and made it clear that it is going to reduce or eliminate as much regulation as it can. The stock market likes these changes, but they are basically stepping on the accelerator at a time when the economy is already at full employment. Usually actions like this are saved for deep recessions when the government must step in and spend money (even if it doesn’t have it) in order to rescue the economy (e.g., 2008).

What does this mean for the stock market?

The Fed has already begun raising interest rates and plans to continue to do so this year. This will act as a bit of a break for the economy. However, interest rates have increased by 1.0% or more 17 times since 1962, and the stock market had positive returns during 14 of those 17 periods. So rising rates are not the worst thing that can happen to stocks.

Inflation, on the other hand, has not so been well received by the stock market. The S&P 500 showed a median return of close to 16 percent in the years that inflation was below 3 percent since 1928. The median return for stocks was just 6.5 percent a year when inflation came in above 3 percent.

Currently, inflation is at just 2.1%, but it is on the rise and making some investors nervous. Now you can see why these things go in cycles.

Questions, comments, thoughts? Drop me a line.

Have a great week.