• Abiye Alamina

Inflation looms... no, a Recession is the problem... or wait


The end of 2018 witnessed very large volatility in stocks and formally put the economy in Bear Market territory - a collapse in stock prices by at least 20% from their prior peak - so the usual question kept cropping up, are we in danger of a recession?

The reason though behind the Fed's decision earlier on in December to increase the benchmark interest rate was that of inflation concerns. Normally, unless we are dealing with supply side shocks, which do not seem to be anywhere present, we expect to see either the one or the other as the malady in question so given these events it is fitting that we ask which problem really seems to be the more pressing of the two.

A brief look at the history of bear markets and recessions in an article by Seeking Alpha suggests that the predictive power of bear markets for recessions is pretty much 50-50. Sometimes recessions follow, sometimes they don't. It stands to reason that the key here in whether a recession is in tow may be how the stock market volatility affects the all important level of confidence in the economy.

To perhaps understand how this current bear market could play out lets perhaps look in a very general sense at what has been going on leading up to this. A very general sense, much like a back of envelope type analysis.

Some have wondered why with all the massive influx of money into the economy from the Fed's asset buying programs to fight off the Great Recession of 2007-09 that we have not yet seen inflation materialize as expected. There are at least two reasons for this which are somewhat obvious from a cursory look at things.

The first reason is the fact that the primary recipients of all that liquidity - depository institutions - have also been incentivized by the same Fed to not push much of the money out into the economy. The Fed has been paying interest on the reserves (IOR) these institutions have with the Fed.

Intuitively, so long as the IOR is higher than the benchmark interest rate, which it has been, we should expect depository institutions to leave their excess reserves with the Fed rather than lend them out. So while there is really an abundance of liquidity so that banks are not in a state of financial panic there is really a Fed induced constraint on the flow of that credit to the public. It is not a credit crunch though since there is already an abundance of credit in circulation, rather this seems to serve more in keeping inflation in check.

A second reason has been the stock market. A part of the monetary policy plan inherent in the Fed's Quantitative Easing (QE) program was to boost stock market prices in order to restore confidence. QE targeted long term government bonds for purchases, lowering their rates and encouraging investors to reallocate into stock holdings instead.

Well, the 'problem' with this is that with higher stock prices there is increased speculation that follows. Investor and consumer confidence having picked up, everyone wants in. With reduced financial regulation (the current administration has already begun to roll back major aspects of the Dodd-Frank Act), risk taking behavior increases, pushing stock prices even higher.

Other than the bubble that this ultimately creates, it should be seen that spending is diverted from actual goods and services to financial asset holdings. This means we have a possible asset market bubble and only very modest upward, if any, movement in goods prices. Some would say that the higher stock prices are driven more by the higher price to earnings ratios which create expectations that stock market growth will persist into the future. However the "price" part of the ratio is where the speculation is probably nested - that is stock prices can still be (and are possibly) overvalued.

So how do we explain the strong economic growth? A rising tide as they say lifts all boats. The economic recovery being boosted by increased confidence and tax cuts not only leads to asset purchases but also increased spending on goods as well, though less than it could have been on the latter. Also, the massive tax cuts for businesses have reduced their costs of production, allowing them to expand production at a cheaper costs. We are experiencing growth from what Nobel prize winner economist Robert Shiller calls a confidence multiplier effect.

It is feasible to see that overvalued stock prices mask what would have otherwise been inflation in the economy. Now the problem though is that this creates an asset bubble that will ultimately go bust and with a reverse effect in the confidence multiplier, it could generate an economic slowdown that could morph into a recession.

So what to make of this situation? Higher interest rates serve to tame stock markets as they lead investors to reallocate their assets away from stocks to interest bearing assets. However it is not supposed to happen in a fit of panic where a huge sellout occurs. It is expected that with the Fed raising interest rates that stocks would fall, but this is normal volatility associated with changing investor preferences. When instead we observe a large fall in stock prices it usually signals either the presence of a bubble or some other shock that spooks the speculative preferences of risk loving institutional investors and risk neutral casual investors.

The odds are we have a stock market bubble, and the Fed's decision to raise interest rates is perhaps appropriate and should continue, albeit cautiously. With all the liquidity being held by financial markets there is no reason to be alarmed. Confidence does not fall when investors are simply incentivized to hold a different set of assets as opposed to when the monetary value of their assets vanish. Therefore so long as the Fed stays the course, this does not have to lead to a recession, but at the same time, this policy does help in stabilizing prices, including stock prices.


So is it inflation or is it a recession that we should be concerned about? If the Fed continues to raise interest rates and manage confidence through forward guidance on this path, then neither. The economy will possibly cool a bit, and unemployment rates may rise, but this would only be expected as unemployment returns closer to its natural rate and stock prices adjust to trading at their true prices.

#bearmarket #financialmarkets #stockmarket #TheFed #Recession #Inflation #stockmarketbubble

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