Field of Play
Fed will not have investors’ backs

You often read comments about the role of the Federal Reserve in the current price level of the stock market. Here are a couple of quotes I’ve read recently to give you a taste of what is being said:
1/ “….is the Federal Reserve controlling the market? It can be concluded that for the moment and likely for the next several months it is likely that the Federal Reserve will be the most important factor in the larger movements of the stock market or at least the role of the Federal Reserve will be.”
2/ “The effort to keep the stock market rising is a part of the Fed’s effort to keep credit flowing into and through the economy.”
It can be read into each of these statements that the Federal Reserve (Fed) is purposely influencing the stock market. Let’s examine that thought.
We know that stock prices are influenced by interest rates, the outlook for company profits and by investor confidence. At any time there may be other influences at work and each of these items can have different roles at different times. We know the Fed uses monetary policy to influence the economy and inflation which, of course, can indirectly influence the stock market. Does it use monetary policy purposely to either boost or restrain the stock market?
Remembering history
We can think about this by comparing the actions of the Federal Reserve in a comparable period. Today’s environment is that we have a richly priced stock market with bubbly craziness in some technology stocks. The period of the mid to late 1990s is instructive.
August 9, 1995 is a good place to start. It was the IPO offering date of Netscape, a small software company that had no revenues and no profits. It gave away its products for free. It was browser software that was created to take advantage of the internet. On its first day the price rocketed from $28 to $71 dollars a share. At that time the whole stock market was hot. It had been rising strongly since the end of the 1990 recession.
By late 1996 the U.S. stock market was priced at 120% of GDP. Six years earlier it had been only 60% of GDP.
In The Age of Turbulence, 2007, p174, Alan Greenspan wrote of his thinking in 1996. He was casting his mind back to what the Fed was facing at that time and how he thought about a hot stock market: “A stock-market boom, of course, is an economic plus – it predisposes businesses to expand, makes consumers feel flush, and helps the economy to grow. Even a crash is not automatically bad – the crash of 1987, hair-raising though we’d felt it to be, had very few lingering negative effects. Only when a collapsing market might threaten to hamstring the real economy is there cause for people like the treasury secretary and the chairman of the Fed to worry.”
He adds: “While the Fed had no explicit mandate to focus on the stock market, the effects of the run-up in prices seemed to me a legitimate concern.”
Irrational exuberance
Then came his famous speech given December 5, 1996 at the American Enterprise Institute dinner. He asked: “…how do we know when irrational exuberance has unduly escalated asset values…?”
The most important thing is what he said after this rhetorical question. The speech went on: “We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability.”
The Dot Com bubble, and it was a true generalized bubble, grew over the next three years. December 1996 was bubbly and irrationally exuberant, but the Dot Com bubble had three more years to run. The Fed did not try to rein in the bubble. It did not raise interest rates. Inflation in the broad economy, particularly product prices, did not soar. The Fed’s attitude at the time was that once the bubble burst, as it surely would, and if a recession ensued, it could step in and ease monetary conditions to help the economy back to health.
Federal Reserve today
I don’t think the Federal Reserve today is trying to promote a strong stock market. Essentially the stock market is collateral to what the Fed is focused on, which is the economy and inflation. Thinking about today’s conditions, the Fed would be aware that strong house and stock market prices can have a wealth effect. As Greenspan put it: “it predisposes businesses to expand, makes consumers feel flush, and helps the economy to grow.” The job of the Federal Reserve is to keep inflation under control and support, as far as it can through monetary policy, a growing economy and high employment. No part of its remit is to either support the stock market when it is weak or rein it in when it’s in a bubble.
Conclusion
The takeaway is that the Fed is in no way trying to make the stock market go up or directly influence the stock market. And further, if a full blown bubble develops, the Fed will not have investors’ backs.
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To dig deeper into the relationship between the economy and the stock market take a look at Chapter 8. The Economy and the Stock Market – Cycles and Trends
To learn more about dealing with bubbles check out the Motherlode Part 5: Asset Management
And specifically Chapter 28. Asset allocation
And Chapter 29. Bubbles, crises, panics and crashes
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For readers wishing to look further into the Federal Reserve and investing, use the search feature on the home page and search ‘Federal Reserve’.
For example, for a discussion of the Fed Model in stock valuation, see
Section 28.03 Stocks less attractive by value standards
For a discussion of the Fed’s role in the Great Moderation of the 1990s, see
Section 29.12 New era talk – this time is different
Readers can also search the term ‘great moderation’ to find blog posts and Motherlode chapters and sections on the topic.
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics for investors.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Chapter Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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