Four percent growth is a lot lower than the 7 to 8 percent growth one would expect after a deep recession. That was the robust expansion pace we witnessed in 1983-84. But 4 percent growth becomes a V in light of pessimistic forecasts of 1 or 2 percent growth, or even a double-dip recession.
Now here’s the rub for stocks: It may be that the Federal Reserve is caught flat-footed in the event of a V-shaped recovery. They may have to tighten policy sooner than planned.
Economist Brian Wesbury, who agrees with the V-shaped scenario, points out that the consumer price index is rising at a 2.4 percent annual rate for the first seven months of 2009. This is a more difficult inflation story than the 12-month change, where we are still deflating nearly 2 percent off of last year’s $150 oil shock. So overly aggressive Fed easing, combined with a weakening dollar, may be generating more inflation pressures than our central bankers think.
There’s a supply-side angle to this story, too. Top marginal tax rates are scheduled to rise in 2011, reducing incentives for future economic growth. However, investors and producers are likely to beat the tax hike by bringing income and activity forward to 2010. This could create a false prosperity next year, which will reinforce the V-shaped recovery even while economic activity is drained from 2011 (possibly setting up a quasi-double-dip). Something similar happened in 1992-93, ahead of the Clinton tax hikes.
So back to stocks. Tuesday’s sell-off -- with the Dow dropping more than 150 points -- could reflect the market’s recognition that the Fed will have to raise interest rates sooner, and withdraw excess cash more quickly, than the easy-money consensus had expected.
A lot of people disagree with this point of view, but I am putting it out there for consideration. It’s not unusual in a stock market/business-cycle recovery to have new production processes absorb excess liquidity while the Fed is withdrawing money from the financial system. That often sets up a brief stock market correction, even though the rise in profits will ultimately carry the indexes to higher levels.
Conservatives need to take note of all this. Disagreements with Obamanomics are vitally important, even in the early stages of economic recovery. But my sense is the Right is too pessimistic about today’s economy. Sometimes you have to take your political lenses out in order to clearly examine the internal corrective workings of a free-market system.
Down the road, heavy government control of the economy will diminish our potential to grow. But that doesn’t mean we must call a halt to the business cycle.