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The Fed Keeps Propping Up the Market—Here’s Why

Jul 05, 2019 | Fred Abadi |

The Fed Keeps Propping Up the Market—Here’s Why

The worst financial crisis in decades—the Great Recession of 2008—sent shockwaves that spread across the globe and impacted every individual and every business. However, despite the rising volatility and risks (for instance, global debt has increased by a stunning $75 trillion), the past decade saw the longest bull market in history.

We must realize just how unusual this is. The fact is this is not an organic bull market but one that central banks worldwide—including our own Federal Reserve—have been artificially propping up. The proof: Every time the markets show the slightest sign of an impending recession, central banks step in.

Why are central banks nurturing the markets?

Officially, the Fed has two mandates: maintain stable consumer prices and maximize employment, but it has taken on the role of not only supporting stock market growth but also nurturing it. This is evident in the chart below.

An economic slowdown is inevitable. Sooner or later, it always happens. But central banks, led by the Fed, are not allowing the normal business cycle to take its course. They have either refrained from tightening their monetary policy or injected new fuel into the markets to support them. Recently, Chairman Powell said the Fed would hold back on increasing interest rates, and President Draghi of the European Central Bank has declared he won’t raise interest rates in 2019, while rolling out a new batch of cheap loans for banks. China is onboard as well, showing a willingness to ease monetary and financial policies.

Why are central banks doing this? Why are they aspiring to maintaining an economy with 2% growth, near-zero inflation, and the need for constant injections of trillions of dollars to prevent it from collapsing? If the financial system has indeed been rebuilt—as our government and central banks tell us all day long—why do they act this way?

The central banks are propping up the market because stocks are a major component of household wealth. These two correlate, so when one goes up, the other one does so as well.

And, household wealth has a significant impact on US consumer spending—growing consumer wealth means higher consumer confidence and increased buying power. In other words, consumers will spend more money.

This is called the wealth effect.

Following the dot-com bubble and during the Great Recession, when stocks plummeted, we experienced a reversed wealth effect, and the Fed is doing whatever it can to prevent this from happening again. The most recent example is from December last year, when plunging household wealth sent the Fed into panic mode, triggering them to boost stock market growth. This will be reflected when the next quarterly household wealth statistics are released—the S&P 500 is up 20% from its December low.

The downside to this short-sighted plan is that, with interest rates as low as they are today, our government has little ammunition to reduce the harsh effects of a recession, which is critical. While I of course do not love recessions or depressions—with rising unemployment, fear, and falling asset prices—they do serve an important role in getting rid of excess. Inventories drop to sustainable levels, and companies that aren’t doing so well go out of business. This enables long-term economic and stock market growth. Unchecked growth over many years typically means overcapacity and high inflation, so although recessions are painful, it’s best to not completely avoid them. Instead, the goal should be to quickly recover from recessions to limit the pain and hardships.

As a consequence of the Fed’s constant boosting of the market, the S&P 500 has been rising much faster than its earnings. It is now at 1929-level valuations. That should make anyone who reads this shiver. And with good reason—a painful market correction is inevitable.

Risky and unscrupulous behavior by our banks caused the Great Recession, yet the banks were bailed out and resurrected by our government. The Fed’s constant stimuli and interventions over the past decade have lulled a whole generation into the false sense of security that the market will never crash and that the Fed will always have their back. As a result, they think they can take virtually unlimited risk.

The Fed is encouraging an extraordinary buildup of risk, but their financial experiment will be proven wrong when, sooner or later, the accumulated risk will overwhelm the Fed’s ability to save the market. When that happens, we’ll not have the tools and means to go through a recession reasonably well, but instead we will witness a historic market crash and the ugly side of the Wealth Effect on consumers’ desire and ability to spend.

More about Fred

With over 14 years in the financial industry, Fred is using his expertise to help Gold Alliance’s clients protect their investments with gold and other precious metals. During his career, Fred has focused on commodities and precious metals as investment assets. He has published several articles on the commodities markets, investing in precious metals for retirement accounts, and other topics. He has been with Gold Alliance for over 2 years as a leading Sr. Portfolio Manager.

Fred is happy to advise clients who would like to diversify into precious metals. You can schedule a free, non-committing consultation with  Fred here.