John RapleyWITH ONE of its most aggressive loosenings of money supply in years, the US Federal Reserve appears to have arrested the stock market slide. Since early in the new year, US stocks have staged a resounding comeback, and the trend continues upwards. Economists now hope that by its actions, the Fed, as it is known in the US, will have forestalled what was starting to look like a slide to recession. So, can we conclude that the worst is past?
Stock brokers have a cheeky expression for a rebound during a bear that is, falling market: a dead-cat bounce. As they put it, if you climb to the top of a skyscraper, even a dead cat will bounce when you drop it to the ground. The question before economists now is, does the recent upsurge in the American stock markets indicate that the worst is over, or is this just a dead-cat bounce?
The current bet among investors is that by slashing interest rates as rapidly as it has, the Fed has ensured a rebound in investment and consumption, both of which had been slumping. Though profits remain poor, it is anticipated that this rebound will translate into a profit resurgence later this year. Analysts are thus factoring this expected future performance into the prices they recommend their clients pay for stocks. And, if their assumption is correct, their prognosis will become a self-fulfilling prophecy. With stock prices rising, firms will be able to raise capital inexpensively, and consumers will have more money to spend. If this rosy scenario comes to pass, the Fed will have pulled off a remarkable feat of economic management: slowing an economy that risked overheating, but then preventing it from tipping into recession. Renewed confidence in the Fed's monetary management will then continue to encourage foreign investors to come to the USA, putting the American boom back on track.
I think the optimism may be unwarranted, though.
Renewed economic activity will come from one of two sources: new investment, or new consumption.
It is true that with real short-term interest rates now approaching zero, the cost of investment has dropped substantially.
But I'm not sure that will, in itself, stimulate new investment, for the simple reason that the investment boom of the last few years has left the American economy with excess capacity. In several sectors, there is too much output and a backlog of inventory waiting to be cleared.
Indeed, it is this inventory that is keeping prices low. Because otherwise, the American economy has a real inflation problem brewing. With wages rising quickly, and productivity declining, profits are eroding. Many economists still think, or at least hope, that the productivity decline is a short-term, cyclical phenomenon that will take care of itself. But my own research suggests that it may be a structural phenomenon. In English, this means the problem won't go away anytime soon.
So, until consumption picks up, profits will continue to disappoint, meaning share prices will probably start to look overvalued. But if consumption does pick up, and the excess inventory is mopped up, production will resume. This will mean the economy avoids recession. But it will also mean that firms will gain pricing power. To recoup profits lost to rising labour costs, they will boost prices. Inflation will then rise, and the Fed will have to reverse itself, raising interest rates yet again, thereby choking investment and consumption whilst eating into profits.
So the way I see it, regardless of whether or not the economy picks up in the next quarter, the outlook for profits is not as rosy as the bulls the optimists hope.
Therefore, I think it is reasonable to expect the stock market to resume its slide sooner or later. Whether the slide returns this year or next probably depends on how bad the situation in the overall economy is right now. But when it does finally resume, the Fed may find itself in the position the Japanese central bank has been in for years.
Having already loosened, it will have no weapons left in its monetary arsenal. So at that point, confidence may suffer badly. Either way, I think the American economy's woes are far from over.
John Rapley is a Senior Lecturer in the Department of Government, UWI, Mona.
