What might happen if the economy starts growing at a powerful clip…say above 3.5% (real, annualized) for several consecutive quarters? Surely sustained growth of the sort would reinvigorate those quelled animal spirits that seem to decline a bit more with each infusion of Federal Reserve cash these days. The reason there is little or no inflation in the economy is because each time the Fed pushes more cash into the system, the velocity of the system declines to accommodate it (i.e., monetary velocity–the measure of how often a dollar changes hands–declines; it is now at an all-time low). You can bring a mortgage banker to money; but you apparently can’t make him spend or lend it.
If money velocity starts ticking upward, as surely it would with robust growth, a by-product will be an increase in the rate of inflation. What then would the Federal Reserve do? First, it would be forced to quit pouring more gasoline on the fire by ceasing its mortgage-backed asset purchases. Then it would be forced to yank some cash from the system, either through increasing the interest rates it controls, or through selling off some of its $3 trillion portfolio of assets.
Though strong economic growth would seem to auger well for the stock and bond markets (and traditionally has), it would instead tend to crush them. Why? Because the stock and bond markets are floating on a sea of dollars poured into the economic system by the Fed. The Fed has done all it could for the last four years to engineer some inflation so that it could solve its unemployment quandary by reducing the real value of wages. Once it succeeds in pushing real wages down (through the mechanism of inflating everything else) to a market-clearing price (as strong growth would imply it had), it will be faced with the daunting task of mopping up liquidity in a system where the effect of its actions will be muted by the increasing velocity of money. Just as the Fed is trying to mop things up, the excess dollars will be making things wetter by becoming more inflationary. Financial markets will suffer tremendously if there is economic growth strong enough to cause inflation.
But financial markets will also suffer if there is economic contraction. Why? Because keeping the markets afloat on a vessel made of paper depends on relatively calm weather. Stormy economic or political weather, domestic or international in origin, and the S.S. Federal Reserve would be revealed as the creaky, poorly constructed vessel upon which to float stock and bond markets that it is, particularly when it’s run out of fuel.
About the only chance of avoiding a precipitous decline from here would be stasis, which in a way is exactly what the Federal Reserve has been seeking with its ZIRP and QE’s I, II and III. It has sought to return things to the way they were before the crash, when there was incessant white noise about the Fed having created a “Goldilocks” economy. And it has now, finally succeeded in returning things more or less to the way they were, but likely not for long. Stasis is not an attribute of financial and economic systems. Like the crowds of humans comprising them, financial markets trend to either lively or despondent, according to the prevailing psychosis. Any appearance of stability is either a temporary way station on the road to disequilibrium, or a delusion. Life, and markets, are never stable for long. Each must be constantly shifting from dissonance to harmony to dissonance again. There is no other way.
Viewed from every possible angle, the financial markets are poised for a fall. It is only a matter of time. But it won’t be today, or tomorrow.