Friday, September 25, 2015

Do the Financial Markets Regulate the Fed?

When the Federal Reserve decided last week to hold short term interest rates at zero, the stock market's reaction was to drop.  Even though easy money has been a shot of glucose for stocks since the 2007-08 financial crisis, the market seemed to be saying that there can be too much of a good thing.

Yesterday, Fed Chair Janet Yellen stated her view that rates should rise sometime this year.  The market reacted positively, even though rising interest rates logically should push stock prices down (since fixed rate investments that compete with stocks would offer higher yields than before).

The implication is that the market is leading the Fed.  The market wanted rates to rise, and when they didn't, the market pouted.  That may have prompted Chair Yellen to make more noise about rates rising, and then the market cooed with approval.

Why would the market want rates to rise when conventional wisdom holds that stocks should love easy money?  Maybe it's because the stock market absorbs information from a variety of inputs, both short and long term.  Easy money is positive in the short run, but can be corrosive in the long run.  Accommodative policy by the Fed and other central banks has continued for almost 8 years now, and is distorting asset values and relationships to the point where the social contract may be changing.  With interest rates so low, the ability of pension funds, insurance companies and other asset managers to provide pension and annuity income is becoming impaired.  (For more, see  When private parties can no longer provide retirement income, greater responsibility falls on the government.  Social Security and similar programs become more essential.  If these programs suffer from fiscal imbalance, taxpayers become more burdened.  We can't toss retired and disabled people into the gutter, but who besides taxpayers can cover their needs?

Another change in the social contract is that easy money favors the wealthy.  Low interest rates have pushed up the value of risk assets--stocks, real estate, commodities and so on.  The distribution of income and wealth have become more skewed in favor of those who need the money the least.  Such growing inequality makes it more difficult to attain social and political compromises and consensus.  A resentful and angry society may lack the optimism and initiative for investment and risk-taking that would foster strong economic growth.  (Note that jaded, cynical Europe is hardly a hotbed of innovation.)

The voices that are heard at the Fed tend to be those of elites--Wall Street executives, influential academics, power players like IMF Managing Director Christine Lagarde.  A lot of these voices have advocated keeping interest rates at zero.  But the accumulated knowledge of many thousands of participants in the real financial world seems to signal that continued distortion of asset values is doing more harm than good.  Maybe the market is regulating the Fed.  And maybe, at least this time, that's a good thing.

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