“When money gets tight, greed turns to fear … “
James Macintosh, The Wall Street Journal
Was the Federal Reserve Board’s unprecedented monetary experiment a success or a failure?
For those who don’t know, the Fed sought to fight the financial crisis of 2007 and 2008 by buying trillions of dollars’ worth of bonds, resulting in interest rates dropping to nearly zero. Other countries throughout the world followed suit.
Zero interest rate policy (ZIRP) theoretically should have caused businesses to invest heavily, since money was so cheap, while also making housing more affordable, since interest payments are the biggest factor in the cost of housing.
While the Fed ZIRPed, President Obama contributed record government spending, including the $836 billion American Recovery and Reinvestment Act of 2009, to stimulate the economy.
Regular readers know that we have not been overly fond of the results, which included a stock market that did not reflect economic reality, tepid economic growth, higher housing prices and the accumulation of a portfolio of bonds that the Fed now has to wind down.
Still Having an Impact
Some will argue that the Fed saved the day. Former Fed Chair Ben Bernanke cashed in with his book, The Courage to Act: A Memoir of a Crisis and Its Aftermath, in which he takes credit for successfully battling the crisis.
The only problem is that the book was written prematurely. The financial crisis may be in the past, but the aftermath of the Fed’s “quantitative easing” program is not yet known.
It’s simple logic that if lowering interest rates helps the economy and the stock market, raising them back to normal levels is likely to hurt the economy and the stock market.
The Fed has managed to boost rates seven times since December 2015 and yet the economy appears to be stronger than it was at any time during the Fed’s bond buying. That’s because tax reform and deregulation appear to be having more of an impact on the economy than the Fed’s actions ever did.
And while the stock market typically shudders whenever the Fed raises rates, the bull market continues. With the Fed recently announcing that it will raise rates four times this year, that’s now built into today’s stock prices.
Fed Actions Impact the World
But of course it’s not that simple. Each time the Fed raises rates it “tightens” the money supply, strengthening the U.S. dollar. The impact is felt in many ways around the world.
The Fed has boosted interest rates to a still-low range of 1.75% to 2% and, as a result of tightening, according to The Wall Street Journal, “Already, bets on low volatility have blown up, money has fled from Turkey and Argentina in particular and from emerging markets more generally, stocks of the biggest banks are under pressure and Italian bonds have been in turmoil.”
While low interest rates create an incentive for investors to take on risk in the hope of boosting returns, rising interest rates push investors from greed to fear, as James Macintosh put it in The Journal.
Macintosh cites research by Ian Harnett, chief investment strategist at Absolute Strategy Research, noting that, “Long periods of easy money have frequently led to excessive risk-taking and large debt build-ups, ending with a bang when monetary conditions start to return to normal.”
Harnett believes that Fed actions have often-unforeseen consequences, not only in the U.S., but worldwide.
“What may seem like unrelated events — including the bursting of the Bitcoin bubble — are symptoms of tighter money, most obvious in Federal Reserve rate rises and the recent jump in the greenback,” Macintosh wrote, based on Harnett’s research.
And while tightening and the stronger dollar may not be the cause of slower growth in Europe and China, it certainly has not helped. As a result, the expectation of a synchronized recovery, with the U.S., Europe and other parts of the world enjoying brisk economic growth, appears to have been a false hope.
“We’re not saying hit the red button and get max defensive, because it could be that China reflates, the dollar comes down again,” Harnett said. “But if the Fed continues to tighten, the dollar continues to strengthen — we think you will see more points of weakness.”
There’s also the irony, not mentioned by Macintosh, that the strengthening dollar is making imports cheaper for American consumers and exports more expensive, just as President Trump is seeking to reduce imports and boost exports.
And, if you’re expecting a soft landing after the biggest monetary experiment in history, keep in mind that it was the Fed that created the financial crisis. Will it be able to continue raising rates without severe repercussions?
We can’t wait to read the sequel.