How Stimulus Made a Soft Landing Harder
The tax cuts and high valuations so many have been cheering have made the Fed’s job even harder—and could end up being the bull market’s undoing
By Justin Lahart
The tax package that got signed into law late last year is complicating things for the Federal Reserve, which faces a situation in which it will be tapping on the brakes as the fiscal policy is pushing on the accelerator. Photo: Pablo Martinez Monsivais/Associated Press
Investors are suddenly worried about just how much the Fed might tighten policy. They should be.
Federal Reserve tightening cycles always tend to get messy. Throw in fiscal stimulus hitting the economy just as the Fed will be trying to cool it down and already-steep bond and stock-market valuations, and this cycle looks messier than most.
Last Friday’s job report provided some of the strongest evidence yet that a tight labor market is finally throwing off faster wage growth. The Dow promptly had its largest point loss since 2008. That wage strength is a sign for the Fed that inflationary pressures are building, opening the possibility that the central bank may have to raise rates faster than it has forecast in order to prevent the economy from overheating.
PRICE CUT
The S&P500´s forward Price-earnings ratio
This is a phase that has always been tricky for the Fed. It mustn’t tighten so little that it falls behind the curve, but also not so much that it sends the economy into a recession. It is something the Fed has only accomplished occasionally, most notably in the so-called soft landing it helped guide the economy to in 1994.
The tax package that got signed into law late last year only complicates things. Lower corporate tax rates and the tax-cut-related bump many people are now seeing in their paychecks will boost the economy this year. The Fed faces a situation in which it will be tapping on the brakes as the fiscal policy is pushing on the accelerator. Making the situation even more complex, nobody knows exactly how much of a boost to growth the tax plan will induce or how long it will persist.
Then there is the matter of markets. Even after the recent selloff, the 10-year Treasury’s yield of 2.84% remains historically low. As a result, it would take much less of an increase in yields to send bond prices down significantly than if at the 4% the notes yielded just before the last recession started.
Stocks are also expensive, in large part because low Treasury yields have made them seem relatively attractive to many investors. Even after the recent selloff, the S&P 500 trades at 17.5 times expected earnings, according to FactSet, near the highest since 2004. That means that stocks, too, could be unusually sensitive to Fed tightening.
The situation might have been very different if today’s fiscal stimulus had come in, say, 2012, points out Robert Barbera, co-director for the Center for Financial Economics at Johns Hopkins University. Back then there was plenty of slack in the economy, with the unemployment rate averaging 8.1%, so the Fed wouldn’t have had to worry about overheating.
It also might not have had to buy assets so aggressively—actions that contributed to today’s richly valued stock and bond markets.
Unfortunately, the Fed and investors aren’t dealing with what might have been, but what is. The tax cuts and high valuations so many have been cheering could end up being the bull market’s undoing.
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