- In a post written three months ago “Has the Fed Created the Conditions for a Market Crash?” we discussed how the Federal Reserve’s program of quantitative easing had set up the perfect conditions for a stock market crash.
- Given the recent turmoil in markets, it seems like a good time to think about how the Fed might react if major declines continue across global share markets. What will the Fed do if equity markets decline by 20% or 30% over the next few weeks or months? Moreover, how effective will any actions taken by the Fed be in circumventing these declines?
- Historically, major stock market crashes (1929, 1987, 2001) have been preceded by a tightening of monetary conditions. What makes this time different is that the weakness in equity markets has not been preceded by any tightening of monetary policy: interest rates have not been raised and the monetary base has not been reduced.
- Indeed, Fed policy over the past six years has been explicitly designed to lower required returns on risk capital, thereby boosting asset prices and, hopefully, real economic activity.
- However, if the required rate of return on risk capital rises sharply at a point where Fed policy is still highly accommodative, then does this begin to make Fed policy look impotent? Will the markets lose faith in the Fed’s ability to manipulate desired market outcomes?
- In the short term, the Fed should retain effective control over the risk free rate. However, it may be very difficult for the Fed to manage the “risk premium”, or the return that is required over and above the risk-free rate by investors in risk assets.
- In the long term, the Fed faces an even greater challenge. The Fed’s likely reaction to a market collapse is either “do nothing” or “do more QE”. However, if the markets begin to believe that the Fed tightening cycle is pushed out “indefinitely”, then this could trigger a sharp acceleration in the rate of inflation. In this worse case scenario, the Fed could lose control over both the risk premium and the risk-free rate.
- The view of The Money Enigma is that the markets perceive the current bloated level of the monetary base to be “temporary” and that it is this perception that is primarily responsible for holding inflation in check over the past six years.
- A stock market crash is just the type of even that could change the perception that the Fed’s program of monetary base expansion is “temporary” in nature. If the markets suddenly decide the current level of the monetary base represents the “new normal”, then this shift in expectations could drive a decline in the market value of money and a sharp rise in the rate of inflation.
Dear Fed, What Happens Now?
Market events over the past few days have highlighted an interesting dilemma for the Fed. What does the Fed do when a policy explicitly designed to boost the price of risk assets suddenly stops working?
Over the past six years, the Federal Reserve has pursed an ambitious and largely experimental monetary policy called quantitative easing. Quantitative easing is designed to stimulate economic activity by suppressing the required return on risk assets, thereby encouraging new investment and business formation. Indeed, boosting asset prices by artificially forcing down the long-term risk free rate on capital is the “primary transmission mechanism” of quantitative easing.
As discussed in a recent post titled “Has the Fed Created the Conditions for a Market Crash?” the purchase of long-term fixed interest securities by the Fed forces down the required return on capital across all asset classes, thereby boosting the price of risk assets. In effect, quantitative easing creates a waterfall effect as investors are forced out of bonds and into more risky investments such as equities and private equity.
Quantitative easing only “works” from a policy-makers perspective if it boosts asset prices and confidence in the long-term economic outlook.
But, what happens if the markets crash and economic confidence is eroded before the Federal Reserve begins the process of reversing quantitative easing?
In this week’s post, we will think about both the short-term and long-term consequences associated with a significant market correction and the Fed’s likely response to this failure of quantitative easing.
Fed Tactics and Short-Term Outcomes
Can the Fed catch a falling knife? If global equity markets continue to fall over the next few weeks, what can the Fed do to arrest the panic?
In the very short-term, there are several tactics that the Fed could employ in an attempt to calm the markets.
First, the Fed could begin by hinting that any interest rate rise in September would be premature. However, this is already largely priced into markets at the time of writing. Therefore, in order to have any meaningful impact, the Fed will probably need to talk down the near-term prospects for the global economy and express concerns about the recent level of global market volatility. The markets will, probably correctly, read this as code for “no interest rate rise this year”. If this doesn’t work, then the Fed could officially rule out an interest rate rise for the next 6-12 months.
If the declines in the equity markets continue, then the Fed could adopt more aggressive tactics. The Fed could begin to suggest that further rounds of quantitative easing are back on the table. It is likely that this would have some short-term positive impact on markets because so many people got caught on the wrong side of the QE trade the first time.
In an extreme scenario, one where markets are down 25-30% from their peak in a short period of time, the Fed could announce a surprise round of quantitative easing designed to “stabilize global financial markets”.
It seems likely that the Fed will employ some combination of these tactics if market declines continue. However, the problem is that none of these short-term tactics really address the key issue.
While the Fed can control the risk-free rate (at least in the current environment) it is almost impossible for the Fed to control the risk premium that is required over and above the risk-free rate.
Over the past few years, the required risk premium has been compressed as investors have chased yield and become more and more complacent about the ability of the Fed to control market outcomes. However, when the risk premium rises sharply in a short period of time, it is very difficult for policy makers to restore it to its previous level in a timely manner.
If the Fed really wants to stop a dramatic decline in the global equity markets, it must make some attempt at manipulating the required risk premium. But given the current design of quantitative easing, this is almost impossible.
The Fed could attempt to control the required risk premium by using additional rounds of monetary base expansion to buy risk assets. In simple terms, the Fed could print money and use it to buy stocks. But this takes the Fed down an even more experimental and dangerous path.
Alternatively, the Fed could simply engage in further rounds of traditional quantitative easing: expanding the monetary base and using the proceeds to buy long-term government securities.
In the near-term, such a response would, at the margin, have some positive impact on risk assets as the purchase of government securities further compresses the risk-free rate, a core component of the required rate of return for any asset.
However, the marginal benefit from such action may be minimal. The risk-free rate is already near historical lows. Moreover, there is no guarantee that lowering the risk-free rate would also lead to any compression in the required risk premium.
In summary, there are several tactics the Fed could adopt to stabilize markets in the short-term. However, none of these tactics are likely to be able to “fix” the core problem, namely, preventing the normalization of the required risk premium.
Moreover, if the Fed does attempt to “catch the falling knife”, then there is a good chance that the Fed will end up with blood on its hands.
In the next section we will consider the possible long-term consequences should the Fed choose to chase the equity market down the rabbit hole. More specifically, we will examine why the long-term marginal cost of more quantitative easing will almost certainly outweigh any short-term marginal benefit.
Fed Strategy and Long-Term Consequences
Over the past six years, the Federal Reserve has quintupled the US monetary base. This represents an extraordinary acceleration in the rate of growth of the monetary base compared to the historical average of roughly 6% per year. So, why hasn’t this dramatic expansion in base money triggered a sharp rise in the rate of inflation?
The view of The Money Enigma is that the only reason the Fed has been able to get away with this aggressive policy and avoid a sharp acceleration in the rate of inflation is because the market believes that the extraordinary recent expansion in the monetary base is “only temporary”.
Moreover, if an event occurs that changes this perception, i.e. if people begin to believe that the recent expansion in the monetary base is more “permanent” in nature, then the value of money will decline sharply and inflation will accelerate dramatically.
A stock market crash is precisely the type of event that could trigger such a shift in expectations.
A few weeks ago, the consensus view was the Federal Reserve would begin tightening monetary policy “any day now”. Most market commentators were calling for the first interest rate rise in nine years to occur next month. This would mark the beginning of a tightening cycle that, ultimately, would see the Fed significantly reduce the size of the monetary base.
Fast-forward to today and perceptions are already shifting. Not only are markets beginning to contemplate no rate rise this year, but respected economic commentators such as Larry Summers are saying, and I quote, “it is far from clear that the next Fed move will be a tightening” (source: twitter).
While it is a matter of speculation, it is not hard to believe that should the equity markets decline a further 10-20% over the next few weeks, there will be enormous pressure on the Fed to stabilize markets by embarking on a new round of quantitative easing. Moreover, if this outcome does eventuate, then it is not hard to believe that market participants will begin to doubt that the Fed will ever restore the monetary base to its previous pre-QE growth path.
While this may sound like a subtle and rather innocuous shift in expectations, the view of The Money Enigma is that this simple shift in expectations regarding the long-term path of the monetary base could mark the starting point a whole new era in global economic affairs. More specifically, it could mark the end of the “low inflation” era and the beginning of a new “high inflation” era.
So, why do expectations regarding the long-term growth path of the monetary base matter to inflation?
In order to understand this point, we need to cover a lot of theory. Given time constraints, we will only touch on the key points today, but those that are interested might want to read two earlier posts, namely “Does Too Much Money Cause Inflation?” and “Why is there a Lag Between Money Printing and Inflation?”
The first concept that must be appreciated is that price level is highly dependent upon the “value of money”. More specifically, the price is a relative measure of the market value of the basket of goods in terms of the market value of money. In mathematical terms, the price level is a ratio of two variables: the market value of goods (numerator) and the market value of money (denominator).
In simple terms, all else remaining equal, the price level rises as the value of money falls and the price level falls as the value of money rises.
For those who are new to The Money Enigma and are not familiar with the “market value of money” expressed as an independent variable, I suggest that you read last week’s post titled “The Value of Money: Is Economics Missing a Variable?”
The second theoretical issue that must be addressed is the nature of fiat money itself. More specifically, why does fiat money have value and what factors influence that value? In other words, what determines the value of the denominator in our price level equation above?
These are questions that we have discussed at length in many recent posts. Readers can find an in-depth discussion of these issues in the “Theory of Money” section of this website, so let’s just focus on the high level points.
The view of The Money Enigma is that fiat money is a financial instrument and derives its value from an implied-in-fact contract. More specifically, fiat money is an economic liability of society and represents a proportional claim on the future output of society.
In simple terms, the value of the money in your pocket depends on long-term confidence in the future economic prospects of society. If money represents a “proportional claim on future output”, then its value is intimately tied to perceptions regarding the long-term economic prosperity of society.
One of the key implications of this theory of money is that the value of money is critically dependent upon expectations regarding the long-term future path of real output relative to the long-term future path of the monetary base.
Until a few weeks ago, the consensus view was that over the next 20-30 years real output growth would be solid while growth in the monetary base, as measured from current extended levels, would be very low. Indeed, most people would have expected that over the next 10 years, real output would grow while the monetary base would decline. These expectations have played a key role in supporting the value of money and keeping a lid on inflation.
The risk today is that a stock market crash could push both of these expectations in the wrong direction.
A major correction in global equity markets may prompt investors to revisit assumptions regarding the long-term growth of the major Western economies. Moreover, a sharp correction in markets could trigger a massive revision in the way that investors think about the future path of the US monetary base.
If investors decide that the Fed will continue to grow the monetary base over the next ten years, rather than reduce the monetary base, then this could trigger a sudden and violent decline in the market value of money.
As discussed earlier, the market value of money is the denominator in our price level equation. A sharp decline in the market value of money could easily overwhelm any deflationary trends in the goods market, leading to a sudden pick up in the rate of inflation.
In summary, investors who believe that the Fed will come to the rescue and catch the falling knife may be in for a nasty surprise. A new program of monetary base expansion may not only prove to be ineffectual in putting a floor under the market, but could also become counterproductive as it acts as a tipping point for expectations regarding long-term monetary base growth, thereby pushing the economy into a new high-inflation era and badly damaging the credibility of the Federal Reserve.