The Federal Reserve is in a battle to dampen economic activity and bring inflation down. Interestingly, it’s the stock market that is making this fight more difficult. The strength of the market in 2024, including the recent all-time high, leads to consumer behavior that complicates the Fed’s mission. That mission, simply put, is to bring inflation down to its target of 2%. The problem with this is that as stock prices continue to rise, the sense of financial well-being among investors also rises. This overall wealthy feeling leads to increased spending, which further stimulates the economy and inflation.
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The Wealth Effect and Consumer Spending
The wealth effect, a behavioral theory, suggests that people tend to spend more when their wealth increases, even if their income remains the same. This seems to be playing out in the U.S. economy. The data behind it includes a recent survey by Gallup, which found that 62% of U.S. adults have money invested in the stock market, either directly or through mutual funds, 401(k)s, or individual retirement accounts. This is a significant increase from previous years and indicates that a large portion of the population is benefiting from the stock market’s performance.
Even low-income households and those in the middle class own a piece of the action. The survey found that 25% of low-income people and 65% of the middle class own equities. This suggests that a significant portion of the population could be enjoying a higher net worth due to the stock market’s performance. According to the theory, this could lead to increased spending, which further stimulates the economy.
The Fed’s Dilemma
The Fed is facing a difficult situation. On the one hand, it wants to control inflation and bring it down to its target level. On the other hand, it doesn’t want to raise interest rates too high and risk slowing down the economy too much. The recent surge in the stock market is making this balancing act even more challenging.
Some analysts, like economist Torsten Slok of Apollo Global Management (NYSE:APO), have drawn a direct link between the Fed’s more dovish policy pivot in late 2023 and the stronger-than-expected inflation readings in the first quarter. This suggests that the Fed’s actions may have inadvertently contributed to the current situation.
The question now is whether the stock market can continue its march upward while inflation remains well above the Fed’s target. Some analysts believe that the Fed may need to raise interest rates again to control inflation especially since the stock market is an added level of stimulus.
However, others argue that the stock market can continue to rise even with inflation above 2%. They believe that as long as inflation doesn’t over-accelerate, the Fed won’t consider raising interest rates.
Key Takeaway – The Wealth Effect Is Leading to Increased Spending
The Federal Reserve is facing a difficult situation as it tries to bring inflation down while the stock market continues to hit new highs. The wealth effect from the market’s strength is leading to increased spending. This consumer spending further stimulates economic activity and makes it even harder for the Fed to control inflation. Economics is referred to as the “dismal science” because it is often the bearer of bad news. The future remains uncertain, but if the Fed can’t meet its inflation target while the stock market experiences growth, then we might see some bad news indeed.
