Is the Fed a pawn of the stock market?
The Federal Reserve’s decision to lower the federal funds rate by 50 basis points on Tuesday is the latest indication that it is becoming an unwitting agent of the U.S. stock market.
Investors had been expecting the Fed to lower interest rates by that amount at the Federal Open Market Committee (FOMC) meeting on March 17-18 in response to heightened fears about the coronavirus outbreak. They were confident this would happen. The reason: They knew the Fed would not want to risk disappointing the markets and be blamed for a renewed stock market selloff.
The decision was made when the stock market began Tuesday by pulling back from a strong surge on Monday. It also occurred after President Trump renewed his criticisms of the Fed.
Despite this, most economists believe Fed easing will have only limited impact on the economy. The main reason is that it cannot counter the effects of quarantines and travel bans that curtail economic activity.
Rather, the intent of policy easing is to bolster investor confidence to sustain the stock market. By doing so, it may lessen the risk that the supply-side shock from coronavirus will morph into a demand shock.
This logic might be used to justify the policy easing. But the Fed must also be aware that repeated actions to bolster the stock market may undermine its credibility.
The origins of the Fed’s overt support for the stock market date back to late 1990s, when Alan Greenspan questioned whether the stock market was subject to “irrational exuberance” during the dot-com bubble. He subsequently backed off amid a flurry of criticisms from investors. When the stock market swooned in the fall of 1998 as Long Term Capital Management was rescued, the Fed lowered interest rates three times. It then left rates unchanged in 1999 even as the economy and stock market boomed.
Thereafter, the Fed’s behavior became asymmetric during stock market booms and busts. The term “Greenspan put” was coined when the Fed was quick to cut interest rates and keep them low following market slumps. But it was slow to raise interest rates when the economy recovered and the stock market surged. This behavior, in turn, gave rise to a series of asset bubbles in technology, housing and the broad market.
Some have questioned whether the stock market is in the midst of yet another bubble today. The bull-run that began in March 2009 is exceeded only by the tech bubble of the 1990s, and it is unrivaled in duration since data were compiled in the 1920s. As of the end 2019, the S&P 500 index was up by 378 percent, far exceeding the average of 164 percent for bull markets, and the duration of 129 months far exceeds the average of 54 months. The U.S. equity market, moreover, has outperformed international equities three-fold over this period.
The only noteworthy correction in recent years occurred at the end of 2018, when the market plummeted in response to fears of Fed tightening and an escalation in the U.S.-China trade war. Thereafter, the market staged a powerful rally last year, rising by 30 percent, even though corporate profit growth stalled. The key drivers were the Fed’s decision to reverse course and ease monetary policy while the Trump administration reached a phase one trade agreement with China.
Investors viewed these actions as clear sailing for stocks. The market continued to rise uninterrupted until the end of February, when complacency gave rise to fear and panic over the spread of the coronavirus.
The Fed’s action failed to calm markets on Tuesday, as the stock market sold off while treasury yields fell. Moreover, it is uncertain what will happen if the coronavirus spreads and the global economy remains weak into the second half of this year. With the federal funds rate down to 1-1.25 percent and the banking system flush with excess reserves, the Fed’s room to maneuver is much more limited than in previous periods of weakness.
Looking ahead, the Fed will have to set policy during an unusually contentious presidential election. Candidates from both sides can accuse it of influencing the outcome. For this reason, the Fed typically prefers to move to the background after the campaign season gets into high gear after Labor Day. The big unknown is whether the stock market will allow the Fed to stay on the sidelines.
Nicholas Sargen is an economic consultant and a lecturer at the University of Virginia Darden School of Business. He is the author of “Investing in the Trump Era: How Economic Policies Impact Financial Markets.”