Spencer Jakab’s July 5, 2019 Wall Street Journal shown above, “Investors Are Trapped in Bizarro World,” puzzles over why the stock market went down after a better-than-expected job report. Let me propose a simple explanation: a Fed that is beginning to do a part of its job better.

Here is the argument:

The Effect of a Positive Demand Shock on the Stock Market If the Fed is Doing Its Job Right

1. To a reasonable approximation, optimal monetary policy is pretty close to keeping output (GDP) at its natural level. This is what I mean by “the Fed doing its job right”—not perfectly according to every nuance in the optimal monetary policy literature, but simply keeping the output gap between actual output and natural output zero to the limit of its ability. Note that if the Fed is doing this, it is not itself a big source of demand shocks because it is being appropriately reactive to events.

2. Define a positive demand shock as anything that leaves the natural level of output the same, but raises the level of the real interest rate necessary to keep the actual level of output at that natural level. Fiscal policy shocks are one possible candidate. But “animal spirits” may be another. In context, I am assuming that a surprisingly good jobs report is often a sign of one of these positive aggregate demand shocks.

3. Assume that higher output (GDP) has a positive effect on the stream of real future dividends a firm will pay out, while a higher real interest rate has a negative effect on the present value of any given stream of real dividends.

4. If the Fed is doing its job well, a positive demand shock shouldn’t change actual output much because the job is to match actual output to natural output and by the definition of a demand shock, natural output hasn’t changed. But then by the other part of the definition of a positive demand shock, the real interest rate should go up. In the usual notation, Y same, r up. Note that “r up” may mean that the Fed won’t cut rates as quickly as people had thought. “r up” is all relative to prior expectations.

5. Y same, so there is no affect on stock prices from that source. But r up tends to make stock prices go down. That’s the end of the argument.

The Effect of a Positive Technology Shock on the Stock Market If the Fed is Doing Its Job Right

Let’s contrast the effect of a demand shock if the Fed is doing its job right to the effect of a positive technology shock if the Fed is doing its job right. My argument for a technology shock takes a different angle, and is somewhat simpler.

1. Keeping the output gap zero as the Fed should be doing, means that the economy is close to doing what a real business cycle model would do.

2. In what is called the “Divine Coincidence,” keeping the output gap zero also (at least approximately) keeps the rate of inflation steady.

3. Typically, real business cycle models predict that investment should go up in response to a positive technology shock. (I have been interested in my research in showing that this is quite general.) If investment is going up, then the value of a firm’s preexisting capital should also go up. Even in fairly general models, the value of firms should on average go up if investment in the economy has increased.

4. Typically, the real interest rate goes up in real business cycle models in response to a positive technology shock. (I have been interested in my research in showing that this is quite general.) This increase in the real interest rate, coupled with inflation unchanged, means the value of a firm’s debt will go down.

5. The value of the firm going up and the value of its debt going down together imply that stock prices should go up.

Conclusion

I don’t want to be mistaken for saying that the Fed is doing its job right. Indeed, I have a long wishlist for how the Fed should improve its conduct of monetary policy. See my post “Next Generation Monetary Policy.” But it is a sign of progress if the stock market has begun to react in both of the ways described above.