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Economics Universe-Two Powerful Opposing Forces

 
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arthur
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PostPosted: Sat Aug 21, 2004 7:54 am    Post subject: Economics Universe-Two Powerful Opposing Forces Reply with quote

Currently, there are two powerful opposing forces influencing the stock market. Falling or low interest rates spur economic growth, while the falling or lower stock market diminishes economic growth.

However, the more powerful of these two opposing forces is the negative "Wealth Effect" of a falling or lower stock market. Low interest rates are less influencial, in the economy, because debt levels are high and the savings rate is low.

Currently, low interest rates have less of an impact on the behavior of U.S. households, since their debt levels are about "maxed-out" and their savings rate are near record lows. Several years of refinancing, borrowing, and depleting savings have put constraints on further household borrowing. So, low interest rates will have a small effect on borrowing or saving for U.S. households.

U.S. firms went through a severe "Creative-Destruction" process over the past few years. This process made surviving U.S. firms "lean and mean." U.S. firms were able to increase output per unit of input at an increasing rate through downsizing. Surviving U.S. firms were able to produce more with less, or the U.S. economy expanded at a brisk rate with few additional inputs, through the more efficient use of "freed-up" resources. So, lower interest rates have less of an effect on output, except for emerging firms or weaker firms on the margin.

Therefore, I tend to believe accelerating inflation is less of a problem than weak employment growth. Inflation may be muted, because demand isn't strong enough to "pull-up" prices and U.S. firms will need to keep prices low to maintain output. Nonetheless, without improved employment growth, the country is in danger of falling into recession. Debt levels need to be paid-down and savings need to be built-up, while consumption (growth) is at least maintained.

Higher oil prices are a "tax" on consumption. The U.S. imports 55% of its oil. So, most of the tax is a foreign tax. U.S. firms can absorb higher oil prices (through lower profit growth). However, U.S. households will have to offset higher oil prices through lower consumption of other goods. The negative Wealth Effect will make consumers feel less wealthy, which may create a vicious cycle of lower non-oil related consumption, causing the stock market to fall further, making Americans feel even less wealthy, leading to even lower consumption, etc.

Also, I may add, the stock market is not a good leading economic indicator. It tends to react and discount at roughly the same time. However, the stock market itself influences the future economy. Therefore, the stock market seems to be a good leading economic indicator. The bond market is a better leading economic indicator, although far from perfect. Bond yields, including the steepness of the yield curve, i.e. between short-term and long-term bond yields (a steeper curve predicts stronger growth), is predicting slower growth.

Therefore, I believe, sustained high oil prices can lead the stock market even lower, preventing a virtuous cycle of employment-income-consumption and instead create a vicious cycle of lost wealth-lower consumption-slowing employment.
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