The Fed’s hope lies in a behavioral economic theory called reverse wealth effect
US stocks extended their gains for the third day Tuesday with the S&P 500 climbing 1.7% as investors shifted their focus to the next batch of earnings and away from the numerous geopolitical risks.
It’s now regained 5% since the low set soon after the release of the latest CPI data on Oct. 13. Such a move upward is generally celebrated by traders — but they should know that stocks’ gains are robbing the Fed of the wealth effect it needs before it can pivot toward lower rates.
The Fed’s hope, he said, lies in a behavioral economic theory called reverse wealth effect, in which consumers spend less as their wealth decreases. That should lead consumers to buy less stuff, particularly on big-ticket items like homes. And that should either prevent or at least slow the much-feared inflationary spiral.
Same goes for the US housing market
Keeping the stock market down for a while matters far more to today’s Fed under Jerome Powell than it did to the Paul Volcker Fed of the early 1980s. Unlike the negligible 14% wealth loss as a percentage of gross domestic product experienced at that time, W5000’s present-day decline is already equivalent to 54% of GDP — nearly four times more.
What is the difference between now and then? In the 1980s, stocks had fallen to an extreme low level relative to the size of the economy.
The belief that politicians couldn’t withstand a major bear market has driven hopes for a Fed pivot that in turn inspired a series of rallies for the stock market.
It’s eminently reasonable to expect that inflation will steadily trend downward from here. But it’s not reasonable to expect it to drop in a hurry all the way to the 2% target.
That implies that the macro-economy is unlikely to offer the chance of a pivot any time soon.
A financial accident caused by draining liquidity might easily force central banks to reverse — but in that case, we would all need to be careful what we wished for.
John Authers Bloomberg 26 oktober 2022
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