Financial markets are as nervous as the proverbial long-tailed cat in a room full of rocking chairs. Take that lesson from stock and bond market reactions to economic news this week. Gyrations of the Dow and other indexes are highly disproportionate to the effective short-term news.
Such market jitters reflect the huge uncertainty underlying the global economy. They will not go away, no matter what the Federal Reserve Open Market Committee does Aug. 8. Nor can new Treasury Secretary Henry Paulson wave some magic economic wand. Right now, forces beyond the control of elected or appointed policy makers dominate the United States and global economies.
The first news out Tuesday concerned the “core personal consumption expenditure” price index tabulated by the Commerce Department’s Bureau of Economic Analysis. These prices rose 0.2 percent in June and 2.4 percent over the last 12 months — the biggest increase since April 1995.
Markets interpreted this as evidence of higher-than-expected inflation and a sign the Fed will continue to constrict the money supply and drive up short-term interest rates.
Prices of both stocks and bonds fell, with the Nasdaq down some 1.4 percent at one point. Lower prices for existing Treasury bonds imply that higher effective interest rates are expected.
The average citizen might wonder what the big deal is. A 2.4 percent inflation number would have been welcome news in more than 30 of the past 40 years. Moreover, 2.4 percent was slightly less than the 2.6 percent increase in the core consumer price index reported July 19 by the Labor Department’s Bureau of Labor Statistics.
The explanation is that while 2.4 percent would be modest for overall inflation, the “core” number headlined does not include food or energy costs. Since energy costs are up at least 20 percent from a year ago and a drought plagues many agricultural areas, a 2.4 percent increase in usually nonvolatile components of consumer spending signals unwelcome overall inflation.
Moreover, analysts believe that for technical reasons, Fed policy makers pay greater attention to the Bureau of Economic Analysis numbers than to the Labor Department’s older and better-known CPI.
A few hours later, markets reacted favorably to Henry Paulson’s first speech as Treasury secretary. Paulson called for reducing the federal budget deficit, especially by curbing long-term deficits in Medicare and Medicaid.
Paulson also toed the Bush administration line by saying, “I believe very strongly that a strong dollar is in our nation’s interest.” No news media I checked noted the irony that Paulson was chosen to head the Treasury specifically because he is considered especially qualified to persuade the Chinese to help weaken the dollar.
Also early this week, equity markets reacted favorably to statements by two presidents of Federal Reserve banks that were interpreted as implying the FOMC might pause in its tighter-money policy. This mimicked the market surge after Fed Chairman Ben Bernanke’s congressional testimony in mid-July.
All this exemplifies an important lesson in introductory economics and finance courses: Anticipated events can be as important as real ones in shifting market prices.
Current levels of market jitteriness are unusual, however. The problem is that while the economic sky is blue right now, storm clouds loom on every horizon. Traders can be excused for jumping when they think they hear thunder.
Crude oil and gasoline prices continue to rise. In the last 50 years, we have never had a comparable rise that was not followed by at least a brief recession. The political situation in the Middle East is becoming more dangerous instead of stable.
Four major economies — the U.S., Britain, France and Japan — have lame ducks heading their governments. The U.S. clings to unsustainable federal tax-and-spending policies, while China, Korea and Japan cling to unsustainable weak currencies.
Something has to give. Traders know that. No one wants to bail out prematurely while the market still is strong, but no one wants to get trampled in any eventual rush to the door, either. And so, the Dow, the S&P 500, Nasdaq and Treasuries yo-yo in response to news that would be ignored if the future were brighter and less uncertain.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.