Be Thankful for the Stock Selloff

The meltdown on Wall Street in recent days might have an upside: It could help extend the length of the expansion.

I had three primary concerns about the extent of the equity rally of 2017 and the beginning of 2018. The first was that it could shift the Federal Reserve in a hawkish direction. The second was that it would extend beyond Wall Street to Main Street, heightening the risk that a market crash would spread through the broader economy. The third was that a selloff would derail the Fed’s interest-rate hike plans and even force it to cut rates. A more modest pace of gains would help ease these worries.

The Fed wisely resists using monetary policy to counter asset-price run-ups. Rate policy is simply too blunt a tool. Indeed, the central bank may not be able to quell a market rally without pushing the economy into a recession. Best then to try to address elevated asset prices with regulatory action that limits the buildup of systemic risks in the financial system, primarily excessive amounts of leverage.

Still, there is a secondary concern about the Fed’s rate hikes to date, which have done little if anything to reduce financial accommodation. The relentless rise in stock prices contributed to these concerns. Without a tightening of financial conditions, the Fed might perceive a need to accelerate the pace of rate increases to restrain inflationary pressures. Unfortunately, a speeding-up of the pace of rate hikes this late in the cycle would raise the probability of a policy mistake and recession. The recent market decline reduces financial accommodation, leaving the Fed more comfortable with maintaining a gradual pace of rate hikes, thus reducing the possibility of a policy error.

Another worry is that high asset price valuations, if they are left to build long enough, will feed through the economy in the form of unbalanced and excessive real growth. A market crash would then rip through the broader economy as an intense recession. This was the experience of the past two cycles. To date though, this cycle has not been characterized by either excessive overall growth or a substantial bubble of activity in any one sector. The expansion has been fairly broad-based.

Taking some steam out of equity prices at this juncture would limit the likelihood of an asset price bubble bleeding into the economy more deeply. By extension, a decline in asset prices would be less damaging to the economy. Moreover, the stock market pullback also limits the likelihood that the economy would overheat. That, too, would help restrain the Fed to a gradual pace of rate hikes.