Its a little disquieting to see the S&P 500 sell off by 5% when an $800-billion stimulus package clears the U.S. Senate and Treasury Secretary Timothy Geithner announces a new rescue plan for banks, homeowners, and the economy. Investors confidence in policy makers has ebbed again, and if the loss in confidence goes too far, it will contribute to the recession.
But it would be a mistake to see the government as powerless. As the recession deepens, it gives the Federal Reserve more scope to monetize debt and other assets. The amounts of new money created will be large, and inevitably will bring out louder prophecies of hyperinflation and other doom-and-gloom scenarios.
But before the wave of new purchasing power reaches an inflationary threshold, the economy has to experience an upswing and reach full employment. That could be another two years or so, given the customary lags lots of time to make a good return in the stock market. The SPDR S&P 500 ETF(SPY) could very well be 20% to 30% higher by the end of 2010 or at least by mid-2011.
Presumably, as the economy approaches full employment, the Federal Reserve will act to withdraw liquidity from the economy. It wont let the economy shoot off into galloping inflation, as many of the gloomy prognosticators seem to be overlooking. Granted, the ride will not be smooth.
As for a collapse in the U.S. dollar and soaring U.S. interest rates, they are not likely to happen while emerging countries continue to repress their currencies in efforts to boost exports to the U.S. and the developed countries. That means they should have accumulations of U.S. dollar reserves to recycle back into U.S. bonds and other assets.