If I did call for an emergency central bank rate cut its not because I think stocks should always go up (even though they do, eventually, by design … I’ll post on survivorship bias some other time) but because this plunge is a clear tightening in financial conditions at a time when rate cuts are already on the table.
Falling stock markets are considered a tightening in financial conditions because they can lead to several economic effects that reduce liquidity and borrowing capacity in the economy:
- Declining stock prices reduce the wealth of investors and households, potentially leading to lower consumer spending and investment.
- A drop in stock prices can increase the cost of equity for companies, making it more expensive for them to raise capital by issuing new shares. This can lead to reduced investment and expansion plans.
- A falling stock market can increase uncertainty and reduce investor confidence, leading to a flight to safer assets like bonds. This shift can raise borrowing costs for businesses and consumers.
- Stocks are often used as collateral for loans. As stock prices fall, the value of this collateral decreases, potentially leading to margin calls and forced selling, further tightening credit conditions.
Overall, these factors can reduce spending, investment, and lending, slowing down economic activity and tightening financial conditions.
If anyone from the Fed is reading this, I can help out. Cut rates and say you meant to do so at the previous meeting but some intern made a typo 😉
Earlier:
This article was written by Eamonn Sheridan at www.forexlive.com. Source