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).

‘The market is rational and the government is dumb’

The above quote is a favorite of former House Speaker Dick Armey (R-TX). He even used to write it on the blackboard on the first day of class when he was an economics professor. Armey has been out of government for years, but as a founding member of a Tea Party group, he’s been a big influence on that wing of the Republican Party. Not surprisingly, he seems pleased with the pounds of flesh they’ve extracted in the new Budget Control Act of 2011.

Armey and I have different ideas of “dumb.” He favors slashing government spending during our Little Depression and also favors a balanced budget amendment that would supposedly compel further slashing. I think those things are time-tested recipes (the times being 1932 and 1937) for worsening a depression. What do the markets think?

The stock market is on track for its eighth straight day of decline (as of 11:55 a.m., the S&P 500 is down 0.5%, and its biggest drop, 2.6%, was yesterday, when the Budget Control Act finally passed). 10-year Treasury bond prices have been rising, and T-bond interest rates falling, over the same span, now down to 2.57%. How to interpret those numbers?

Hard to do, because nobody (as far as I know) takes scientific polls of market participants to ask them why they did what they did. Armey would probably say, as some commentators have, that stocks have tanked because the $2.1 – 2.5 trillion in cuts over a decade aren’t enough. I would say, as have others, that the market is reacting to the dismal state of the economy and to the likelihood that, as basic macroeconomic theory tells us, the spending cuts will make it even more dismal.

What about bonds? The rosy view would be that T-bond prices have improved because the debt-ceiling vote means no default through 2012 and the spending cuts reduce the overall burden of debt. Armey and I might actually agree that the unrosy view is correct: T-bonds are in higher demand because of a worldwide “flight to safety,” as grim economic news causes people to move away from risky, cyclical assets like stocks and toward safe assets like T-bonds. Again, is the grimmer news the “failure” to slash spending more or the weakening economy?

I’m thinking Armey’s quote fits right now, except it’s the budget bloodletters who are dumb and the markets are rationally reacting by anticipating that they will cause further hemorrhaging of the economy.

P.S. At least one market participant agrees. From the Aug. 2 Financial Times:

‘Jim Reid, strategist at Deutsche Bank, . . . has warned the US could be approaching a “1937 moment” – when authorities removed post-Depression stimuli from still-fragile markets and triggered another recession. This risk, he says, has in fact only been magnified in the markets’ eyes by agreement on raising the US debt ceiling.’

(Hat tip: Brad DeLong)