How Today’s Fed and the Markets are Linked

Before we discuss how the two are now connected, it might be helpful to quickly look at the Federal Reserve’s history. The Fed was established in 1913 to act as the “lender of last resort,” with a mandate to maintain price stability-in other words, keep inflation low. However, the Fed soon moved outside its original mandate and helped create the roaring 20s. Keeping rates artificially low fueled a rise in debt and a subsequent speculative frenzy on Wall Street. In 1928 the Fed aggressively raised rates to crack down, leading to a recession and market crash. The Fed then initially lowered rates, but out of fear of reigniting inflation raised rates soon thereafter. This caused a banking crisis which turned into the Great Depression.

After World War II the world had changed and inflation was held in check until the 1970s. To help pay for the Vietnam War and the Great Society, President Johnson leaned on the Fed to keep rates low even though government spending ballooned. The Fed caved and, as a result, inflation ran rampant. Then in 1977, Congress gave the Fed a dual mandate, to maximize employment in addition to keeping rates low.

When Paul Volcker became Chairman, he decided to bring stability to prices once again. Interest rates rose significantly, economic output dropped and unemployment rose–ushering in a protracted recession. However, in the end, stagflation was defeated and an extended period of prosperous growth began.

In 1987, President Reagan appointed Alan Greenspan to replace Volcker. Like Reagan, Greenspan was noted for his laissez faire attitude toward the markets and regulation. He believed the markets were more efficient with self-regulation and as Chairman fought against bank and derivatives regulation.

Early on as Chair, Greenspan was faced with Black Monday, the day in which the Dow dropped more than 500 points. To ensure liquidity, Greenspan lowered rates and was credited with saving the U.S. from a repeat of 1929; however, he also set a precedent for intervention even before signs of any economic impact. Then in 1997, the Federal Reserve intervened again and bailed out Long-Term Capital. In addition, Greenspan quickly reduced rates three times in the coming weeks. These interventions became known as the Greenspan put. Investors learned to rely on Greenspan to rescue the markets if trouble developed. Following the bailout, the Tech Bubble ensued. When it exploded, Greenspan again reduced rates and when 9/11 occurred in the following year, interest rates were again lowered with a series of cuts. While the economy was spared, the availability of cheap credit provoked the U.S.’s first real estate bubble.

During this period, Bernanke replaced Greenspan as Chairman with a promise of staying the course. But of course, the real estate bubble burst, the stock market plummeted, and the economy dropped. The cause of this woe was the massive growth of debt-by consumers, banks, and investment banks alike. To keep the system from collapsing, Bernanke nationalized Fannie Mae and Freddie Mac, bailed out the banking system, and reduced rates further. But this was not enough.

To push investors into riskier assets (e.g. stocks) the Fed began its quantitative easing (QE), whereby it bought government debt and poured money into the banking system. As a result, government debt soared and so did stocks. When QE ended and stocks declined, Bernanke initiated QE2. When the same thing happened again, QE3 was introduced. As a result, stocks are up over 200% from their 2009 lows. This is not by accident. Both Greenspan and Bernanke have stated that rising stock prices will increase employment. In essence, the Fed has consciously pushed stocks higher to fulfill its second mandate-maximize employment. Of course this is not a free lunch-someone has to pay. The taxpayer is now on the hook for trillions of dollars of new debt. Yields have plummeted, which has taken a toll on savers. People living off the interest from their CDs, bank savings, or bonds have seen their income erode to virtually nothing.

So, through deliberate intervention, the Fed has pushed stocks higher and bond yields lower. The quick expansion of credit, which triggered our bubbles, has only gone higher. Greenspan, and now Bernanke, believed that the government should not intervene in the markets, but by their very hands, have shifted the Fed to be central in setting stock prices.

Join me in my next blog when we look at the current price of stocks.

 

Washington Trust Bank believes that the information provided was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.

 

---