Nearly 6 years now, on 16th December, 2008 the Fed cut its already very low funds rate to the 0.00% – 0.25% range and hasn’t touched it ever since. One has to go back over a hundred years to see the same type of stability in rates and indeed, it pays testimony to the depth of the crisis we were faced with in the dark days after Lehman’s collapse.
Investors, borrowers, citizens, and the government: all have been enjoying the best period ever to spend or put money into whatever they wish, as it is almost free. The party has gone on for too long and, if the Fed’s forward guidance is to be taken into account, it is not over yet.
During the 1950s, interest rates were also low, but the Fed has made history in cutting them to zero and in keeping them so low for such a prolonged period. It has never happened before.
If we look at the chart below, depicting the evolution of the effective federal funds rate over the years, we can clearly discern a trend. The funds rate has been declining since a peak at 20% in 1980 to its absolute minimum at zero in 2008. The truth is that, if we look at the evolution of the inflation rate over a similar period, we identify some connection between inflation and interest rates. They have largely moved in tandem as one would expect as the interest rate should follow inflation, that is higher inflation results in higher interests to try and curb it and vice versa.
But, as of recently, and in particular since the 1990s, the Fed has not only been keeping interest rates low but has also been much more active than in the past. “Helicopter” Ben Bernanke, for example, cut base rates 10 times before setting them at zero, and that happened in little over one year. That was not a reaction to low inflation but rather to the sub-prime crash. In 2000, a similar strategy was followed by Alan Greenspan, as he cut base rates 13 times in a row, from 6% to 1%. That again, was not a reaction to low inflation but rather a reaction to the dot-com crash. In recent history, then, reductions in interest rates have been a reaction to equity market crashes and are deemed at inducing a full equity market recovery post the crash. This is a huge change in monetary policy and in fact is not part of the Fed’s mandate which is supposed to be stable inflation and full employment. If you look at the 1987 crash, for example, you won’t find a similar action. The FED cut rates from 7.25% to 6.25%, but that was all.
During both the dot.com and sub-prime crashes, the Fed has responded with extreme action. They are now more aware of market crashes and are prepared, and willing, to act to reverse the situation. They are the firemen of the equity market, we could say. The problem with this approach is that sometimes a fire is needed in order to make way to build new foundations, and the Fed is resolutely not allowing for that.
The Fed has not been fighting inflation or deflation, nor has it been attempting to boost growth in the first place. The Fed is playing with equity prices, assuring wealth is preserved in the stock market, at any cost it seems. The stock market is said to reflect the state of the real economy. If it disconnects from fundamentals, it will have to catch up again at some point. After the crash, the gap became so great that the Fed needed to drastically cut key rates and even purchase assets to drive prices higher. However, this is a nonsensical game that is preventing markets from truly healing and it is plain for all to see that the U.S equity market in particular is now disconnected from the economic reality.
According to the Fed’s position on the matter, markets are “rational” (patently they are fans of the discredited Eugene Fama EMH theory that CYNK Technology singularly disproved only last week see HERE), so there is no such thing as a bubble. Prices reflect all expected rational future cash flows, at all times in the Fed’s world. Let’s say we accept that. Then, why did the Fed cut rates 13 times in a row after the 2000 crash? Why did the FED cut rates 10 times after the Lehman collapse? Aren’t prices rational? Presumably high prices are rational and low prices aren’t?
High equity prices represent a disconnection with reality and have often been the result of artificially low rates that push investors towards riskier assets without regarding risk profiles. Low prices under such context are simply the result of the bursting of the bubble, so represent a return to rationality. Under this dynamic, a crash is a desirable outcome. Please, don’t take these words the wrong way! We said desirable not necessary. If the Fed avoided such an extreme intervention allowing for the crash to occur, only pushing interest rates down later if needed (or at least letting them revert sooner), we probably wouldn’t have seen the sub-prime crisis. And, if the Fed had increased rates during the 1990s, we probably wouldn’t have seen the dot.com bubble either!
Many crashes could be avoided if the Fed didn’t play the rational/irrational game at their own discretion. But, as we believe, Bernanke, Greenspan, and Yellen are not naïve (they all do have something in common though!). They know all that. We can only assume they do it on purpose, and that is not because they follow the free market orientation from Chicago, nor is it because they follow the Keynesian pack from Washington. They have simply been redistributing wealth, assuring that the money lost during crashes is returned, principally to the banks, and at the cost of the individual investor who is, as ever, attracted to the market at precisely the wrong time, just to see his money vanish in the next crash…