Let's Play Why Did the Market Fall?

February 07, 2018

CEPR

Yes, boys and girls, it’s time to play “Why Did the Market Fall?” This is when you get to blame who or whatever you like for the big plunge in the market that began last Friday (now largely reversed).

I want to blame the partial unwinding of the Affordable Care Act, which is likely to leave millions more uninsured and tens of millions paying more for their health care. I have a friend who wants to blame her uncle’s bad breath. Then there is Andrew Sorkin at the NYT who tells us that investors fear that Donald Trump’s tax cuts will succeed all too well, causing a boom which will generate inflation.

So the Sorkin story is that we get a big uptick in demand from the tax cuts, which will push the economy above its potential level of output creating a good old-fashioned wage-price spiral. That will mean higher interest rates and therefore lower stock prices.

If we want to test this one we can look at measures of investors’ expectations of inflation. On January 31, just before the plunge, the yield on 10-year Treasury bonds was 2.72 percent. The yield on an inflation-indexed 10-year bond was 0.61 percent, implying a gap of 2.11 percentage points. On Friday, the day of the first big plunge, the yield on the 10-year Treasury bond rose to 2.84 percent, while the yield on the inflation-indexed bond rose to 0.7 percent, giving a gap of 2.14 percentage points.

That’s 0.03 percentage points more than before the crash. Do we really want to say that an increase in the expected rate of inflation of 0.03 percentage points will sink the market? Of course, the gap was back down to 2.10 percentage points at the end of the day on Monday, so it’s not clear what happened to investors’ fears that the Trump tax cuts would spur inflation.

Okay, we get that Sorkin is apparently very fearful of inflation and presumably thinks the Fed has to be very vigilant on the inflation watch. He doesn’t even care if he lacks the evidence to make his case.

(It is worth noting that if the Trump tax cuts “work” it is supposed to be by spurring a flood of new investment. That should increase productivity growth, which would relieve inflationary pressures. So if Sorkin has a vision of Trump’s tax cuts causing inflation, he seems them “working” in a different way than has been advertised.)