The stock market hates uncertainty

Posted: Apr 18, 2005 12:00 AM

On April 15, the Dow Jones industrial average fell 191 points, the largest one-day decline in almost two years, causing the Dow to end the week 4 percent lower than it began this year. The Dow has fallen more than 850 points (7.8 percent) in the past six weeks.

The stock market decline does not, in my opinion and that of Treasury Secretary John Snow, reflect fundamental problems with the U.S. economy. The economy is actually sound, and absent new policy errors by the Congress or the Federal Reserve Board, it should continue to grow in the neighborhood of 3.5 percent a year after accounting for inflation. But we can do much better.

Granted, if the price of oil remains above $50 a barrel, there will continue to be economic friction and drag as resources are reallocated across the economy. Any time there is a rapid major reallocation of resources due to an economic shock, it takes its toll on economic growth in the short term. However, if monetary policy would be certain and focused on meeting the demand for liquidity, rather than attempting to fine-tune the resource reallocation, and if taxes and tariffs are not raised or regulations increased, the economy will adjust and continue to grow.

The stock market's problem right now is precisely the uncertainty investors face. The Fed kept monetary policy too loose for too long, looking to job growth rather than liquidity demand to set its course. Now we are destined to suffer through a bump-up in inflation as the excess liquidity the Fed created over the past several years works its way through the economy. We can expect to see around 2.5 to 3 percent CPI inflation before it is all over.

On the tax front, the uncertainty is really causing investors to take pause. President Bush ran for re-election on a platform of making the tax cuts permanent, and he increased his congressional majorities in both houses of Congress doing so. Yet no one is making a serious enough effort to make the tax cuts permanent any time soon. The best we can hope for now, it appears, is a short-term extension of the tax cuts, and even that is not yet a certainty. This is a huge disappointment to investors and entrepreneurs.

To make matters worse, some influential members of the Congress have put tax increases on the table by considering raising the wage limit on Social Security payroll taxes. That is playing with fire, especially as investors watch the administration's campaign for personal retirement accounts struggle. Some fear a tax increase will be the price for getting personal accounts enacted into law - definitely not an acceptable tradeoff.

Trade policy remains uncertain as calls for protectionist action against China increase.
If ever there is an economic fallacy loose in the land, it is the one that our rising trade deficit is a sign of economic weakness and is caused by too much free trade. To the contrary, as economic growth among our trading partner lags, they import fewer American goods. While the U.S. economy continues to grow and be a magnet for capital and imports, a tariff war would be suicidal.

On the bright side, the Fed has indicated it is aware of the inflation problem, and since the Federal Open Market Committee last met, the dollar has strengthened some, the price of gold has declined from its recent highs and the price of oil is back down to $50 a barrel. Fed Chairman Alan Greenspan recently reiterated his concern.

While some of the run-up in the price of oil has been reflective of past monetary policy mistakes, the fundamental problem with oil is that Congress refuses to take measures to increase domestic exploration and production, and both the federal government and the states impose excessive regulations that prevent refineries from being built. Until this all changes, we should continue to expect price pressures on oil.

What Greenspan was doing with his recent statements is reassuring markets that the Fed will not overreact to rising oil prices and seek to accommodate them by pumping up the money supply to ease the friction and drag they cause in the economy. That was precisely the mistake Fed Chairman William Miller did back in the 1970s, when the Arab oil embargo drove the price of oil through the roof. By pumping up the supply of liquidity in an effort to offset the pain of resource reallocation in the face of skyrocketing oil prices, the Fed short-circuited markets from bringing the economy into balance and in the process touched off the horrible inflation of the late 1970s and early 1980s. It took Paul Volker and Ronald Reagan's election to restore pricing stability.

The markets can take bad news, but if the economic fundamentals are basically correct, as they are currently, markets adjust and continue to rise. It is uncertainty the market hates, and it is uncertainty that is driving it down right now. Until the uncertainties over tax, trade and monetary policy are dispelled, the stock market will continue to be in for bumpy sledding to the detriment of people's desire to work, save and invest.