A stock correction, a sharp turn in financial conditions and the impact of the stock market on the entire economy

For stocks, central bank rates are not among the direct most important variables determining their value. Although with the amount of talk about rates, such a claim may be surprising. And it can be doubly true if I write that rates are not that important for the economy as a whole.

The last year or so has brought reflections that the American economy is not as sensitive to rates as before. The reason is obvious – despite the noticeable monetary tightening, there was no significant cooling of the economy. Inflation did the opposite, which was overall an ideal combination. This is probably due to the fact that inflation was influenced more by supply pressures. Or there is another possibility – the behavior of demand, which has been less sensitive to rates for some time now, but still quite sensitive to other factors, played a significant role. They thus point to the following graph, which shows the financial conditions given by developments in the capital and currency markets.

With FP, you can see a massive relaxation from the autumn of last year, which lasted until recently. Even though the Fed did not move rates during this time. There has now been a fairly sharp jump upwards to tightening, which appears to be largely a reflection of inflation developments and subsequently truncated rate cut forecasts. Financial conditions are therefore influenced by monetary policy, but not only by it and especially not only by its current state, but also by its outlook.

Source: X

We are thus watching the wheel in live transmission, when the vision of the future easing of monetary policy was already loosening financial conditions, which in turn reduced the need for monetary easing. Now that wheel is turning, the tightening of (albeit still loose) financial conditions, given fewer expected rate cuts, is itself strengthening the case for tapering. At best, this mechanism has some centripetal tendency. Today, however, I would like to focus on the fact that a significant component of financial conditions is the behavior of the stock market. This is also evident from the timing of chart changes. But why is that so?

The stock market can influence the economy through several channels. Its movements should be reflected in the required return on real investments. On a “softer” level, they should influence the sentiment of both companies and households. And they also talk about the so-called wealth effect – higher stock prices mean more wealth, which should support the real purchasing power of the population in addition to the sentiment itself. And conversely. How strong could this effect be?

There are more studies, I will point to the relatively young Stock Market Wealth and the Real Economy: A Local Labor Market Approach. In it, Gabriel Chodorow-Reich, Plamen T. Nenov, and Alp Simsek argue that “for every dollar of growth in stock wealth, consumer spending increases by 2.8 cents.” From a rough calculation, it follows that a 10% growth in the stock market would raise the product, or aggregate demand, by 0.5% with this effect alone. Which seems like a lot.