24 December 2018

The Federal Reserve's Christmas Gift: A Bear Market

Wall Street has little to celebrate this Christmas holiday, courtesy of a recklessly stubborn Federal Reserve. During the previous week, from 17 December to 21 December of 2018, the Dow Jones Industrial Average shed 6.8 percent of its total--the worst such performance since the 2008 "Great Recession." Such has been the turmoil among the major stock exchanges that Treasury Secretary Steve Mnuchin caught many observers by surprise when he called the major US banks on 23 December to address concerns of financial stability and the general availability of credit.

Yet is any of this really so surprising?

Consider a few basic facts:
A reasonable question to ask at this juncture is why would interest rate hikes precipitate stock market declines? The immediate answer is simply this: money.

The total supply of money in any economy varies inversely with interest rates. Lowering interest rates expands the money supply, and raising interest rates shrinks the money supply. The Federal Reserve's tweaking of interest rates is quite intentionally an effort to manage the total money supply in the United States. During 2018, Fed Chairman Powell opted four times to shrink the money supply.

When the money supply shrinks, prices are inevitably pushed downward, for when there are fewer dollars in circulation, each dollar has greater purchasing power, all else being equal. Stock markets, where prices fluctuate by the second, display this phenomenon faster than other portions of the economy, where prices are slower to change.

When the money supply shrinks, there are also fewer dollars available to lend--a reduction in the money supply is a reduction in the availability of credit.

Given that Powell's past two interest rate hikes have precipitated a deep and persistent stock market decline, and given that interest rate hikes are by definition a reduction in the availability of credit, is it really so outrageous that Secretary Mnuchin would be concerned about financial stability and credit availability? Is it not more outrageous that Jerome Powell is not concerned about these things? 

Certainly, Powell has a duty to be concerned, because the primary stated mission of the Federal Reserve is to conduct "...the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy." A price drop among stocks of 6.8 percent in a single week is not exactly what one would call price stability.

Yet Powell has been amazingly "tone deaf" to the consequences of Federal Reserve rate hikes. Within the mission of maintaining stable prices, the time to raise interest rates is during periods of significant inflation--something that has been conspicuously absent from the US economy. When there is no inflation, raising interest rates is an action calculated to destabilize prices--by causing them to drop.  Powell has even acknowledged this by his assertion that the economy is "strong enough" to absorb the rate hikes and corresponding money supply and credit reductions. The stock market decline was what he wanted--he unilaterally decided that stocks were "overvalued" and so elected, on his own initiative, to erase a few trillion of market capitalization.

No wonder President Trump would like to fire him--Trump has been clamoring against the rate hikes, correctly predicting that the money supply shrinkage would precipitate a stock market collapse. Market turmoil and declining share prices are not the way to "...promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy." By all appearances, Jerome Powell has been seriously derelict in his duty as Federal Reserve Chairman. If he were the Controller or CFO of any major US company, he would have been fired by now.

Sadly, this bit of financial Kabuki has been played out time and again throughout America's history--dereliction is rather the norm at the Federal Reserve.  Pushing interest rates too high too fast catalyzed bursting the 2006 housing bubble, and thus the subsequent 2008 financial crisis--the metastasis of which was itself the product of both government mistake and lax execution of established government regulatory responsibilities.  

Similar errors occurred in 1999 and 2000, when the Federal Reserve raised interest rates in the face of stock market declines, precipitating a recession beginning in March of 2001.

Even the calamitous stock market crash of 1929, widely viewed as the onset of the Great Depression, was triggered by an abrupt change in monetary policy by the New York Federal Reserve Bank, which raised interest rates to 6 percent.

That interest rate hikes catalyze stock market declines and crashes is absolutely established by the constant correlations between them.  One can view this correlation in one of two ways: The Federal Reserve erred by letting the money supply grow too much, causing the stock market to overinflate into a bubble, forcing a correction to be taken, or the Federal Reserve erred by deflating stock prices in the absence of any signs of price inflation in the broader economy.  One theme, however, is consistent--that the stock market declines and subsequent recessions are the consequence of Federal Reserve error.

Which begs the question of why we continue to empower the Federal Reserve to manipulate interest rates and the money supply in this fashion. Invariably, they get it wrong, and because they get it wrong there has there has not been a single decade of American history since the creation of the Federal Reserve in 1913 when there has not been major stock market and economic turmoil. Too much or too little, but never just enough is the basic pattern of Federal Reserve regard for interest rates.

One could even argue that the Federal Reserve's mission is impossible to complete.  Every interest rate adjustment by the Federal Reserve is an intrusion into the marketplace. Every interest rate adjustment is therefore a disequilibrium of the marketplace--and stable prices require equilibrium. The very thing the Federal Reserve does to carry out its assigned task is the very thing that causes it to fail at its assigned task. At the very least, expecting the Federal Reserve to ward off financial crisis by intruding into the markets is quintessentially insane behavior--repeatedly doing the same thing expecting different results.

Instead of constantly fiddling with interest rates and triggering economic upheavals, perhaps the Federal Reserve should adopt a novel approach to maximizing stability--do nothing.

Or is that expecting too much common sense from government bankers?

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