When Good Economic Data is Bad News

The Economy is Damned if it Does and Damned if it Doesn’t

Graph with two arrows — Vector by Anthonycz

In understanding a typical normal economy, there’s a pretty simple formula to follow: If the economy is going well, and economic data verifies this, then economic sentiment will be high, and more people will feel content. Many people will have decent-paying jobs, and their retirement accounts will likely be doing well. Overall sentiment will be hopeful and contented.

But in the same way that you can’t really measure Newtonian physics in a vacuum, you can’t really measure the economy without taking into account some underlying headwinds, namely inflation.

We’ve been blessed with 40 years of relatively low inflation. There have been recessions about once every decade, but that is less frequent than the historical average rate. Even taking those into account, economic growth and strength has been persistent.

During this 40-year period, you could count on the formula I mentioned above to apply most of the time. Good economic data was good news, and bad economic data was bad news. Pretty simple, right?

Well, now that the specter of inflation has reared its ugly head, the rules have become highly distorted. Inflation eats away at profits and makes it harder to earn “real” money. If you are earning 5% in a savings account, a stock account, or with bond yields, but inflation is increasing at a 5% rate, you’ve essentially earned nothing. So therefore, as inflation goes higher, interest rates go higher to compensate. But at the same time underlying assets, such as stocks and bonds, go down in value because their rate of return is no longer attractive in a high-rate/high-inflation environment.

Inflation is a scary thing for everyone. Regular people see their cost-of-living increase, which makes everything more expensive, and makes it harder to live from day to day. And investors get spooked because their most popular sought-after investments return a lower relative rate of return.

So, when economic data suggests that inflation might go higher, investors tend to become pessimistic. And what kind of data suggests inflation might go higher? Good, positive economic news. This is because if people are feeling good, making money, and buying things at a high level, the chances are higher that prices will continue increasing due to high demand. The economy will stay “hot”, so to speak. The goal in general is for the economy to be “warm”, not too hot and not too cold, often referred to as the “Goldilocks Economy” (please don’t make me explain the Goldilocks reference).

That is the current conundrum we are in. On the one hand, good economic news is good, more people are employed, making money, buying things, etc. But in a period of high inflation, such as we have been in recently, good economic news is bad, increasing the chances of further high inflation. 

It can be a vicious cycle; there is even an economic indicator for “Inflation Expectations”, which is important to gauge because it reflects how behavior could change to keep the cycle going. If people expect inflation to be a problem, they may be more inclined to demand higher wages, which would increase labor costs, which could get passed onto all consumers. It could also force people to accept a state of higher cost of living and instead of slowing their spending, they increase it and just deal with the consequences of lower disposable income or lower savings.

Therefore, at this time good economic news would be something that shows the economy slowing down. If it can slow down a little bit, that might have the intended effect of easing people’s concerns about inflation, thus lowering their inflation expectations, thus lowering inflation itself, without creating major hardships across the population. A few tenths-of-a-percent increase in the unemployment rate, for example, or weekly jobless claims going from the low 200,000’s to the mid-to-high 200,000’s, could show that the economy is slowing to some degree. But these levels would still be historically good, and a sign of a resilient economy that is relatively strong without being too “hot”.

The data coming out these days reflects a confusing mix that is both comforting and worrisome at the same time. On the one hand inflation is coming down, from the yearly peak of 9% to the current level of around 3%, but the reported levels have not reached the 2% benchmark that the Fed targets. Job growth has slowed in recent months to encouragingly “warm” levels, but the weekly jobless claims has remained stubbornly historically strong, indicating a very tight labor market, which could push costs higher. Real wages (adjusted for inflation) have increased, fortunately, but oil and housing continue a steep increase even beyond the base rate of inflation, and paint a picture of being on the verge of an unaffordable society.

At some point, higher interest rates and higher costs should have the intended effects, as they make getting consumer loans harder and more expensive, which should result in tampering down demand, and somewhat slowing the economy. We have to hope the data keeps showing a continuing economic slowdown, but not too harshly in the negative direction, to avoid going into a recession, if not something worse down the road. In other words, for the long-term benefit of everyone, at least temporarily, we are in the awkward position of having to root against the economic instincts we’ve been accustomed to for 40 years.