If markets could talk

The stock market would be telling the Fed something like this:

Sounds crazy, but that’s how present discounted value works. (And thanks to my daughter for the meme.)

This week the Dow fell 3% this after Fed Chair Ben Bernanke’s announcement that eventually the economy would get better and then the Fed would gradually take its foot off the accelerator. That is, the Fed would taper off its quantitative easing (QE; emergency mass purchases of long-term bonds) when unemployment (now 7.6%) fell to 7.0% and then, as announced before, would start raising short-term interest rates back toward normal levels when unemployment fell to 6.5%. He didn’t say this was going to happen soon, and reiterated that the (near-) zero interest rate policy would continue until unemployment falls to 6.5%. Granted, he sounded mildly optimistic that the economy would recovery sooner than expected, but he presented no new data on that score, so it’s an easy prediction to shrug off. Not that the markets did.

The present-discounted-value approach to stock pricing says that a stock is worth its company’s expected future profits in all years to come, divided by a discount factor that is based on the long-term interest rate. The lower the interest rate, the higher the stock’s price should be. The odd thing here is that if the economy picks up, corporate profits should too, which should offset the higher interest rates that Bernanke is hinting at. It may be that corporate profits are already high and are not always easy to predict, whereas long-term interest rates are known now. The 10-year Treasury bond rate rose from 2.2% to 2.5% after Bernanke’s announcement, a 14% increase that is right about in line with the 15% drop in stock prices. (The 10-year Treasury yield is still at a near-historic low, by the way.)

The financial media tend to report any significant-looking drop in stock prices as an economic calamity, overlooking the most basic facts about the stock market, namely that it is volatile and its short-term swings have very little macroeconomic impact. The less we worry about short-term market reaction to the Fed, the better off we’ll be. Jared Bernstein has an excellent piece on the Fed’s announcement, to which I don’t have much to add, only to say that I don’t see much new in the announcement, other than some optimistic predictions and an exit strategy for QE (which had to end sometime).

Something to sneeze at (the new employment report)

Friday’s big economic headline was that the unemployment rate fell to 7.5%, the lowest since 2008. And payroll employment rose by 165,000, somewhat better than expected.  The news was good enough to push the Dow Jones average over 15,000 for the first time, and it obviously could have been worse, but what an age of diminished expectations we are in. Almost four years since the 2007-2009 recession officially ended, and we’re at 7.5% unemployment. The comprehensive “U-6” unemployment rate, which includes all discouraged job-seekers and part-timers who want to work full time, actually edged up slightly to 13.9%. And the employment-to-population ratio was essentially unchanged at 58.5%. All not good.

As for the why and what do we do now, Jared Bernstein nails it a lot better than I could.

Oil!

Rising gas prices are on everyone’s mind again, as the price of oil has risen some 25% (about $25 per barrel) in the past year and the price of gasoline inches ever closer to $4 per gallon. While 1970s-style stagflation appears unlikely — the price of oil quadrupled in 1973-75, so even another 25% or 50% increase seems comparatively small, and industry has become less oil-intensive since then — the implications for the overall economy are still not good.

Alarmists often exaggerate the importance of oil prices on the economy — the bar for ridiculousness was set last week by Donald Trump, who said the 2008 financial crisis wasn’t about the banks but high gas prices — but here in today’s inbox is Nouriel Roubini, as credentialed a Cassandra as you could ever ask for, saying:

‘Today’s fragile global economy faces many risks: the risk of another flare-up of the eurozone crisis; the risk of a worse-than-expected slowdown in China; and the risk that economic recovery in the United States will fizzle (yet again). But no risk is more serious than that posed by a further spike in oil prices.‘

Roubini does not blame the 2008 crisis on oil, but he does say that the previous three world recessions were touched off by geopolitical shocks in the Middle East — the Arab oil embargo and 1973-75, the Iranian revolution and 1979-82, and Saddam Hussein’s invasion of Kuwait and 1990-91. He links the current rise in oil prices to fears that Israel will attack Iran, which may be developing nukes but definitely has lots of oil. He says oil supplies are currently plentiful and world demand remains weak, reflecting the weak economy, but that the fear factor is driving the increase. Some players along the supply chain may be hoarding oil in anticipation of higher prices caused by a disruption of Iran’s oil production. Many investors are buying futures contracts for oil at ever-higher prices, which will tend to raise the demand for oil now (since oil now and oil later are substitutes). The NYT has a fuller analysis.

Just how much of a drag on the economy would a spike in oil and gas prices be? First, just a small increase would put the price of gas over $4 a gallon, which would seem like a psychologically important “nominal anchor” (i.e., not many would notice if gas goes from $3.96 to $3.98, but if it goes from $3.98 to $4.00, alarm bells will sound). This would likely be a blow to consumer confidence, especially now that winter is ending and longer car trips are feasible. The price of gas is probably the most closely watched economic variable, more so than GDP or inflation or unemployment or even the Dow Jones average, so this negative effect could be large. Throw in the reduction in consumers’ real income and the increase in business costs, and how big a hurt does this put on real GDP? Jared Bernstein says the rules of thumb “say a $10 increase in a barrel of oil translates into about a quarter more per gallon at the pump, and, if it sticks, could shave 0.2% off of GDP growth.” Yet unlike Roubini he puts oil #2 on his list of threats to the recovery. #1 is fiscal drag, i.e., continuing government spending cuts in our already demand-starved economy. (Europe is his #3.)

So we might have already lost 0.2% in GDP growth, and the projected additional 20-25% increase in oil prices if Israel attacks Iran would mean about another 0.3%. Not enough to derail recovery, but enough to make it noticeably more anemic than it is already.