Movements in the stock market often convey information about where investors think the economy is going. If investors expect good economic times, stock prices generally rise, while stock prices fall when investors think the economy is headed for a downturn. When investors are uncertain about the economy’s future, stock prices become volatile, with large swings in both the positive and negative direction. Often, we look to the Dow Jones Industrial Average to gage how the overall stock market is doing. The recent huge swings in the Dow Jones Industrial Average, both from day to day and even within the same day, suggest investors do not have a clear consensus on where the economy is going.
Like investors, I am unsure about where the economy is headed. On the one hand, the economy may do very well in the next two years. The economy tends to grow at an average rate of about 3% a year. If we have a few years of slow or negative growth, these down years are followed by several years of above average growth, which brings the average growth rate back up to 3%. Even in an extreme case, like during the Great Depression, when the economy faced a severe contraction, the economy responded by growing faster than normal, and today we are no poorer having had a Great Depression than we would be if this terrible economic calamity had never occurred. Consider recent times. Since 2007, the economy has grown at an annual rate of only 2.39%, suggesting that we are due for some above average growth to bring the average growth rate back up to 3%. By this reasoning, the near future should hold good economic times.
On the other hand, a plausible case can be made that we will have a severe economic downturn in the next two to three years. While the downturn could stem from several different causes, here is a likely scenario. The story begins back in August of 2007. At this time, the Federal Reserve (Fed) held $0.87 trillion in assets, which were mostly bonds. Then the financial market collapsed in 2007-2008 and the Federal Reserve started buying bonds to increase the money supply in the economy, with the hope that the extra money in circulation would cause people to make more purchases, which in turn could keep a severe recession from getting even worse. The Fed bought so many bonds to pump money into the economy that the value of its balance sheet rose to $4.5 trillion by January 2015.
In 2015, there was a potential problem, namely that increases in the money supply could cause inflation. Today, we face the same potential problem since that extra $3 trillion that the Fed pumped into the economy is still there. The value of the Fed’s balance sheet on Feb. 12 of this year was still $4.4 trillion. This money seems to finally be having an effect because wages and prices are rising. In general, if the increases in prices accelerate, we will attain levels of inflation that will cause concern at the Fed. Inflation does so much damage to the economy that the Fed will feel compelled to sell many of its bonds to remove money from the economy. The Fed will find it nearly impossible to know how much money to remove and when to remove it. Consequently, the Fed often overreacts and takes so much money out of the economy that people are discouraged from making transactions, which in turn often throws the economy into a recession.
If I were a betting man, I would not want to make a bet on a good or poor economic future. I think the stock market is correct in signaling that the fortunes of the economy could go either way.
Joe McGarrity is a professor of economics at the University of Central Arkansas.
Contact him by email at firstname.lastname@example.org.