Yellen’s Stock Market Shock: Economic Forecasting in the Short, Medium and Long Run

  • The US Presidential election has acted as a catalyst to reflation.
  • The Obama Administration has quadrupled the US money supply, while the real dollar exchange rate has appreciated.
  • The tightening of the US job market creates upward pressure on wages and inflation.
  • The Trump Administration’s efforts to reverse corporate inversion could flood US capital markets, further placing upward pressure on inflation.
  • A contraction of US money supply is needed to restore financial markets to equilibrium as artificially low interest rates have distorted price indicators.
  • FED funds rate hikes might not be effective as rational expectations emerge. A balance sheet selloff may be more appropriate to combat inflationary pressure.
  • Expectations will act as a key driver to anticipated inflation.
  • Short term wages will remain sticky as firms take advantage of short term real profit gains.

Inflationary pressure has brought some attention for monetary policy to increase interest rates. Since the Election of Donald Trump, the stock market has gained almost $3T in value. Regardless of warnings to investors brought about by Janet Yellen, inflation seems to have picked up along with consumer confidence. Adaptive expectations have now become rational and consumer sentiment has taken the drivers seat.

While monetary policy has flooded US capital markets with currency, the dollar has appreciated. Much of this has been attributed to massive corporate inversion holding offshore profits. Corporate inversion has effectively counteracted money supply manipulation, resulting in a reduced effectiveness of demand side monetary policy stimulus.

Repatriation has now become of interest by the Trump Administration. Over $3T in US capital is held overseas to avoid US taxation. What would the effect be if repatriation of US dollars was enacted? This paper seeks to analyze the components of such a proposal.

Consumer confidence and expectations are incredible forces. The spread of optimism across the country has brought about the increase in stock market valuation, with a bond selloff and allocation to equity investment. Expectations of reduced taxes, domestic manufacturing and optimism has the potential to spur inflation. As inflation brings wage increases, a counterbalancing effect should occur, which is supported by a tightening labor market.

Given the fact that we are exiting a global deflationary cycle, we can expect to see interest rates increase along with wages. We can also expect an interest rate increase to put appreciation pressure on the dollar.

Given these counteracting forces, how will we expect the Trump Administration’s policy

As supported by the current administration, the depreciation of the dollar is expected to allow companies to better compete in the global manufacturing sector, a long time source for middle class wages. As relative dollar strength works inversely with commodity prices such as oil, the Trump Administration is in favor of higher oil prices. Real business cycle theorists would suggest the effect would promote domestic manufacturing, exasperated by the sensitivity of transportation costs to energy prices.

The Fed still has an issue with interest rates effect on Federal debt servicing. This is an area where El Don’s policy becomes complicated. Given his proposed $1T reduction in government spending, he conversely intends to increase military spending by 10%, or $54B. He also proposes a $1T infrastructure bill, financed through private and public sources. Where do we get this money? Growth alone?

Another element exists that effect the outcome of interest rates: money supply. With decade long current account deficits with US trade allies, the US dollar has consistently exited our economy. The US trade deficit has placed upward pressure on the US dollar. A reduction in real exchange rates with US trade partners has resulted in massive corporate inversion, further compounded by high domestic taxation.

Should this money become repatriated, the natural interest rate could effectively decrease. A flood of US currency into US capital markets would increase the supply of money and could potentially further exasperate inflationary pressure if monetary policy remains constant. A selling off of the Federal Balance sheet could be a potential approach the FED would take. This could be more effective as a direct approach to money supply contraction.

Rational expectations take hold when inflation rises and higher volatility exists. In such an economic climate, Federal Funds rate increases are inferior solutions to balance sheet selloffs. As the US has experienced a decade of low interest rates, ample supply of credit has distorted price indicators used by money managers to properly allocated capital. A balance sheet selloff could therefore act as a more effective approach to the Trump Administrations intent to repatriate offshore profits of US corporations.

The FED could see this as concerning to inflationary pressure. Yellen has already indicated the intent to begin selling off balance sheets. However given the US Federal debt; debt servicing payments would increase. A conundrum is therefore created. Should the FED raise interest rate payments on its own debt to restore the US economy to a natural equilibrium state? How would government debt affect the private sector?

One of the other factors in determining whether inflation will result in benefit to an economy is to understand the unemployment ratio relative to economic growth. Currently our labor force is shrinking; while we have seemed to meet jobs demand.

Should there become an increase in labor demand, we can expect labor rates to increase. As we have seen an increase in separations and quits, people seem to feel optimistic about their job prospects. This optimism can create new entrants into the labor force, distorting the unemployment rate and creating a countercyclical correlation. As there becomes an increase in labor demanded, upward pressure is put on wage rates, particularly in the service providing sector, with professional and business services adding 71,000 new jobs, education and health 47,000 jobs, and trade, transportation & utility services adding 63,000 jobs in January.

Below are a series of graphs posted by the Bureau of Labor Statistics that reflect the current labor market.

Series Id: JTS10000000JOR
 Seasonally adjusted
 Industry: Total private
 Region: Total US
 Data Element: Job openings
 Rate/Level: Rate

Series Id:     JTS10000000TSR
Seasonally adjusted
Industry:      Total private
Region:        Total US
Data Element:  Total separations
Rate/Level:    Rate
Series Id:     JTS10000000TSR

Seasonally adjusted

Industry: Total private

Region: Total US

Data Element: Total separations

Rate/Level: Rate

It appears that we have a really strong job market. People feel optimistic by their economic prospects, and inflation is a representation of this. We’re optimistic especially given the current concerns with a strong dollar, high inflation, increasing interest rates, and deficits. An increase in separations is an indication that people feel optimistic about their economic prospects to seek alternate jobs. We have additionally been adding more jobs than losing, at 247,000 jobs added in January, reported by the national ADP report.

Given the positivity of such economic figures, we can assume economic growth in the medium run. In the short run, we recommend shorting the market, as a pullback is expected with unexpected interest rate increases. Long run however, expect for consumer confidence to propel the market to further highs.

We’re in for an economic expansion, and will see how much speculation creates a bubble that’s bound to correct itself with a recession at some point.

John Walsh, Independent Analyst