Why the Stock Market Drives the Economy - Not the Other Way Around


Since its 1977 inception, the Federal Reserve has operated under the mandates to maximize employment, curb inflation, and moderate long-term interest rates. Since the days of the Greenspan put, one can add stabilizing the U.S. stock market to its modus operandi. I would argue that the original mandates have taken a backseat to stock market stabilization. Why? The stock market is the tail that wags the dog due to its effect on U.S. consumption. Here’s what I mean:

When breaking down the components of GDP in the U.S., 68% is personal consumption, 17% business investment, 17% government spending, and -3% net exports. According to a 2018 study entitled “Stock Market Returns and Consumption,” the lower 50th percentile of households in terms of wealth distribution consume 33% of every dollar made in capital gains, demonstrating clearly that rises in capital gains acquired through stocks influences consumer spending. The inverse wealth effect works too on a surprisingly short-term basis. In May of 2018, personal consumption fell by 200 bps after -3.89% S&P 500 yields in February and -2.69% in March. GDP rises and falls with consumption while consumption rises and falls with stock prices. 

Furthermore, these moves become exacerbated because consumers have pumped money into the market at an alarming rate. At 65.6% market cap to GDP in 2008, the stock market has ballooned to 1.5 times the size of the entire U.S. economy (154% market cap to GDP). With the amount of money in the stock market and the effects that price movement has on consumption, the stock market IS the economy.

Jerome Powell's recent dovish pivot in the wake of the December rate hike made it clear that the Fed watches the markets just as much as the markets watch the Fed, likely due with an understanding of the implications of declining stock prices on the real economy.

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