Fed says: Stock market be damned.

… and, the market responds predictably.
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Yesterday, Fed Chairman Jerome Powell took a meat ax to the market.

As expected, the Fed inched interest rates up a notch — as planned, and as expected.

That’s OK … the economy need to be weaned off of near-zero interest rates.

But, despite indicators of an economic slowdown, Powell said there are still more interest rate boosts on the table for next year … count on ’em.

Pundits expected a more wiggle-roomed statement that the Fed would be watching what happens and be driven by the data.

Then, he deliver the coup de grace, saying “financial markets and the Fed’s balance sheet don’t matter.”

Au contraire, Mr. Powell.

The financial markets matter to folks holding financial assets … and the Fed’s balance sheet – a correlate to the supply of money in the economy – is a major determinant of financial markets’ strength.

Need proof?

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Let’s start by taking a stroll down memory lane ….

Over 40 years ago, an economist-wannabe co-authored a study in the Journal of Finance titled “The Supply of Money and Common Stock Prices”.

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The article summarized an econometric study (think: big, hairy financial model) that demonstrated a tight link between the amount of money floating around and, on a slightly time-delayed basis, the price of stocks.

That is, when the Fed adds liquidity into the market (think: “quantitative easing”), much of money flows into the stock market – rocket-boosting stock prices.

And the opposite is true. When the Fed tightens, stock prices fall back into earth orbit.

OK, fast forward to today.

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In a WSJ column, famed economist Martin Feldstein sounded some warnings about the soaring stock market:

Year after year, the stock market has roared ahead, driven by the Federal Reserve’s excessively easy monetary policy.

To deal with the Great Recession, the Fed cut interest rates to a historic low.

Fed Chairman Ben Bernanke explained that this “unconventional” monetary policy was designed to encourage an “asset-substitution effect” with investors pouring the added liquidity into equities and real estate.

The resulting rise in household wealth was expected to push up consumer spending and strengthen the economic recovery.

The strategy eventually worked as Mr. Bernanke had predicted.

The value of equities owned by households increased 47% between 2011 and 2013, and overall household net worth rose nearly $10 trillion in 2013 alone.

When interest rates rise back to normal levels, share prices are also likely to revert to previous norms.

In short, an excessively easy monetary policy has led to overvalued equities and a precarious financial situation.

The result is a fragile financial situation—and potentially a steep drop somewhere up ahead.

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Mr. Powell is making Prof. Feldstein look like a genius … and, oh yeah, demonstrates that my long ago thesis has some current day relevance.

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#HomaFiles

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