What does the stock market plunge mean for the economy?

Neil Irwin, New York Times
February 6, 2018

Horse race image
Image source: Pixabay

Despite the horrific 8.5% drop in the S&P over the last few days, our economy is doing just fine.

The stock market, while critical in the long run for individuals accumulating wealth and businesses raising capital, typically runs with such volatility as to make it meaningless in the short run. So while this recent drop could predict the coming of a global recession, it could also just mean some computer trading programs are firing erratically.

What really matters?

It is important to look at the well-being of the economy as a whole and the ability for individuals and companies to prosper in years ahead. To do that, we must look at fundamental economic data, especially those meant to be leading indicators of economic prosperity.

The economic data has been solid in recent weeks. Just Friday, the Labor Department reported that the United States added a robust 200,000 jobs in January. The Federal Reserve Bank of Atlanta tracks incoming economic data to estimate current growth of gross domestic product, and its indicator is pointing toward robust economic expansion — a 4 percent annual rate.

The Institute for Supply Management said its index of activity at service companies rose sharply in January, which made it one of those curious days when good economic news coincided with a steep market sell-off.

Next, we must look at the bond market and other financial market indicators, as they are more reliable measures of investors’ expectations than day-to-day stock prices.

The bond market is also looking optimistic about the future, with prices suggesting that continued growth — without inflationary overheating — is the most likely future.

The stock market has lost ground since the start of the year, thanks to the sharp sell-off Monday. But the yield on 10-year Treasury bonds is up in that span, from 2.4 percent to 2.75 percent (as of late Tuesday morning). That suggests bond investors think that continued steady recovery will allow the Federal Reserve to raise interest rates gradually.

Int Rates graph

Bond investors are pricing in higher inflation than the United States has experienced in recent years, but roughly in line with the 2 percent the Federal Reserve aims for. Prices for inflation-protected bonds imply 2.09 percent annual inflation over the coming decade, up from 1.98 percent at the start of the year.

It is useful to think of the economy like a horse race. What we really care about is which horse wins, places, or shows. The bond market is the equivalent of people betting directly on the race. In comparison, the stock market is like a weird side-action game where people bet on which gambler is going to have the best day. This makes it erratic, volatile, and slightly removed from the actual race on which it is all based.

Sure, a sudden drop in the stock market could indicate coming economic turmoil. But it could also be a sideshow to the broader trajectory of the United States and global economies, which according to the numbers, currently look fine.

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