Family Feud, a popular game show when I was growing up, would ask contestants to guess how a group of people had answered a specific question. It served as a regular and early reminder for me of the importance of supplementing one’s thinking with external perspectives.
If, in the tradition of Family Feud, we were to poll market participants about the turmoil we’ve seen since Friday’s worse-than-expected US jobs report, I suspect we would get quite specific responses on what is causing the global stock selloff as well as what would be the best circuit breaker to avoid further big losses. Let’s consider what I think that list would look like before departing from the game show’s format and exploring what I believe the answers should be.
Five things have come together to destabilize what seemed to be fundamentally solid stock markets. Here they are in order of declining importance.
First are worries that a slowdown in US economic growth would meaningfully undermine the much-admired “American exceptionalism” we’ve witnessed over the past few years. Such a deceleration would damage corporate earnings and turn the strongest engine of global growth into a possible detractor.
Second is concern that the feared economic downturn will be worsened by the Federal Reserve’s decision last week not to cut interest rates, which left its policy stance too restrictive for the current environment and heightened the risk of another big policy mistake.
Third is crowded investment positions being caught offside by the sudden change in both the economic and policy narratives. This squeeze was further amplified by concerns of a Japanese-related deleveraging and sky-high valuations in certain segments of the market such as technology stocks.
Fourth on the list would be geopolitical worries centered on the possible escalation of the conflict in the Middle East, which, in turn, would cause a stagflationary spike in oil prices and complicate the functioning of international supply chains.
Finally, there are domestic political developments resulting in what is likely to be a messy run-up to the US presidential election in November.
How about views on the best circuit breakers?
Again, in order of declining importance, the markets favor: First, the Fed signaling a 50- or, even better, 75-basis-point cut in September. Second, an emergency inter-meeting cut of that magnitude. Next, verbal intervention from the Fed to calm markets. And finally, market bottom-fishing/dip buyers; followed by verbal intervention from the Biden administration.
What about my own assessment?
The first list corresponds closely to my thoughts about the contributing factors, but I disagree on the circuit breakers.
Given what we know today about the economy, every circuit breaker listed above that requires Fed intervention would constitute a policy overreaction that could well backfire in the longer run. I say this despite having argued in the run-up to last week’s policy meeting that the central bank needed to begin its easing cycle with a 25-basis-point reduction.
Rather than allow itself to be bullied by markets, as occurred in the fourth quarter of 2018, the Fed should stand on the sidelines and let the market overreaction (and that’s what I believe we are seeing in government bond yields) play out.
This would need to be followed by the Fed making a credible attempt to regain control of the policy narrative by being more strategic in its guidance, adding a serious forward-looking component to what has been its excessive backward-looking data dependency. Its efforts will only be effective if, simultaneously, it is more explicit about several of the important open policy questions detailed here, including where it sees neutral interest rates (a level at which policy is neither holding back nor stimulating the economy); and an examination of the secular and structural changes taking place in the domestic and global economy.
Chair Jerome Powell’s keynote speech at the upcoming Jackson Hole conference will provide an important opportunity to take charge of the narrative and ensure the Fed start acting as a stability anchor rather than an amplifier of excessive market volatility. Failing to do this risks two unfortunate outcomes: undermining US economic exceptionalism, and the country’s international standing and contribution to global economic well-being; or adding to the already notable moral hazard in markets, where too many have been conditioned to believe that it is the Fed’s role to protect them from the unsettling volatility that comes from excessive risk-taking.
Little did I know decades ago that Family Feud would serve as my early introduction to the value of the insights provided by behavioral economics and finance. It is always important to ask what is expected, how these expectations influence behavior, and how far they are from what we think is appropriate. It is also important to recognize the risks involved when what is expected and what is appropriate fail to converge.
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