Don’t worry about stock-market volatility: It is perfectly normal. Do worry about how stocks got so high to start with because it is evidence of an economy still abnormally dependent on low interest rates and richly priced assets.
The 2,271 point drop in the Dow Jones Industrial Average in the week through Monday at 9% didn’t even meet the usual 10% threshold for a correction. Tuesday’s 567-point rebound, at 2%, didn’t crack the 500 biggest one-day rallies. And even more reassuring, the selloff was driven by the most banal of reasons: worries about inflation and interest rates.
An inflation scare is an entirely different animal from the deflation scares that have rocked markets over the last decade including the U.S. financial crisis of 2008, Europe’s government-debt crisis of 2011, and China’s slowdown in 2015. Each of those events tanked, or threatened to tank, a key economy and push inflation into negative territory. In each, investors bet on more central-bank measures to prop up growth.
This time it isn’t growth, deflation or more central-bank stimulus that preoccupies investors but the opposite. Last Wednesday, the Federal Reserve released a statement in which it predicted “further” gradual interest-rate increases. The word “further,” which wasn’t in December’s statement, subtly signaled more conviction higher rates are in order. Then Friday’s report on January job growth was accompanied by the largest annual increase in wages since 2009.
During deflation scares, investors sought safety in government bonds, driving their prices up and yields down. Now U.S. bond yields are rising, standing near a four-year high as of Tuesday.
Inflation results from the economy pressing up against its productive capacity. That is a fundamentally bullish development. Higher wages and profit estimates aren’t the precursors of a recession or a prolonged bear market.
True, if inflation sustainably pierced the Fed’s 2% target, that would usher in much higher interest rates, and probably recession.
But why wring one’s hands over the prospect when inflation, excluding the volatile food and energy categories, has been stuck below 2% for five years and hasn’t hit 3% in a quarter-century?
Yet if the stock-market downdraft isn’t worth fretting over, the same cannot be said about the backdrop in which it happened, starting with that quiescent inflation picture. It has taken nine years and the lowest unemployment since 2000 to produce even a modest uptick in wages (and even that may prove fleeting). That shows how an aging population and lackluster productivity represent powerful and persistent headwinds to long-run growth even if U.S. tax cuts have raised the short-run outlook.
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