The Real Economy Improves, Financial Markets Disapprove

The government reported 224,000 net new jobs created in the month of June, well above “expectations,” an indication that the real economy is doing well. About 100,000 a month is enough to absorb new labor force entrants due to population growth. But, financial markets did not celebrate, closing in negative territory. Apparently good news for the real economy is not good news for Wall Street. “Traders” in the markets had bet on weak data and a Fed interest rate cut this year, “pricing in” at least one rate cut in their trades. No rate cut means no payoff from the bets. And so, the market sold off, stocks closed lower.

Asset valuations are at record high levels. The only way to get higher stock prices is to have an improvement in earnings, which doesn’t appear to be in the cards — or, get the Fed to cut interest rates. This makes all stocks more valuable (holding constant all other factors that might affect the share price of a company). When Chairman Powell suggested at this Chicago Listening Conference that the Fed would consider cutting rates this year, the stock market gained 500 points, a solid vote of approval for rate cuts from Wall Street.

Wall Street has some welcome support for rate cuts from the Federal Reserve itself. Many members of the Federal Open Market Committee (FOMC) have expressed concern that the Fed has been unable to coax inflation to reach its arbitrary 2 percent target, based on the headline Personal Consumption Expenditures price index. Supporters argue that lower interest rates will encourage private spending and push inflation over the 2 percent goal. However, there is scant evidence that this will work based on our experience since 2008. What matters is not the cost of money, but the potential earnings that can be made from investing that money in real terms, capital spending, and that depends on prospects for the economy. The talk on Wall Street is all about “weakness,” globally and domestically. Maybe we can talk ourselves into a recession and an end to the longest economic expansion in history. That would be a shame.

A rate cut now would not move the spending needle on Main Street where it counts for improvements in productivity and capacity. Complaints about credit availability are at 46 year lows, and reported interest rates on loans are historically low as well. NFIB reports only 3% of owners say they didn’t get all the credit they wanted and only 4% said that loans were harder to get. Only 2% said that credit was their most important business problem, one percentage point above the record low reading. Anything worth funding can be funded in the current environment. What Wall Street doesn’t need is another artificial boost in share values. They already have a long way to fall to be normalized relative to the output from the real economy. The ratio of consumer net worth to GDP (stuff we make and can be bought) has risen to a record $5.20 per dollar of GDP, up from a pre-dot com bubble average of $3,50. Lots of claims on stuff that we make, but not much more stuff.

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