Is the Fed trying to steer markets away from monetary policy? Such was the interesting introduction from former British diplomat Alastair Crooke through the Strategic Culture Foundation, to this effect:
“The Fed, however, may try to effect a reverse, controlled collapse of the US bubble economy by raising interest rates. Rate increases will not kill the ‘dragon’ of inflation (they would have to be very high to do so). The aim is to break the general ‘habit of addiction’ to free money.”
It’s a powerful assessment that, if true, has significant implications for economic and financial markets over the next decade. This is especially important when considering the impact of these repeated monetary and financial interventions on financial market returns over the past decade.
The chart below shows the average annual inflation-adjusted total return since 1928. I used public return data from Aswath Damodaran, a professor at the Stern School of Business at New York University. The chart shows that from 1928 to 2021, the market returned 8.48 percent after inflation. Note, however, that after the 2008 financial crisis, returns rose by an average of four percentage points for different periods.
We can directly trace those large returns to the Fed’s repeated monetary interventions and government fiscal policies during that period. After the financial crisis, the Federal Reserve intervened with monetary support every time the market crashed or threatened the “wealth effect.”
While many would like to suggest that the Federal Reserve’s monetary interventions do not affect the financial markets, the correlation between the two is very high.
However, the result of more than a decade of unlimited monetary experimentation has resulted in a huge wealth gap in the US economy that has become front and center on the political scene.
It’s not just the massive expansion of household net worth since the financial crisis. The problem is that almost 70 percent of that household net worth is in the top 10 percent of income earners.
While it likely wasn’t the Fed’s intention to cause such a massive redistribution of wealth, it was the goal of its massive monetary experiment.
Pavlov’s Great Experiment
Classical conditioning (also known as Pavlovian or response conditioning) refers to a learning process in which a strong stimulus (eg, food) is paired with a previously neutral stimulus (eg, a bell). Pavlov discovered that when he introduced the neutral stimulus, the dogs would begin to salivate in anticipation of the strong stimulus, even if it was not present. This learning process consists of the psychological “combination” of stimuli.
This is what happened to investors in the last ten years.
In 2010, then-Fed chairman Ben Bernanke introduced “neutral stimulus” to financial markets and added a “third mandate” to the Fed’s responsibilities – creating a “wealth effect.”
Bernanke wrote of the “wealth effect” in a November, 2010 Washington Post Op-Ed:
“This earlier approach eased financial conditions and, so far, appears to be effective again. Stock prices rose, and long-term interest rates fell as investors began to anticipate this increased activity. Easier financial conditions will boost economic growth. For example, lower mortgage rates would make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates would encourage investment. And higher stock prices would increase consumer wealth and help boost confidence. , which can also increase spending. Increasing spending will lead to higher incomes and profits which, in a positive context, will further support economic expansion.”
Importantly, for conditioning to work, when a “neutral stimulus” is presented, it must be followed by a “reinforcing stimulus” to complete the “pairing.” For investors, the stock market rose as a “strong stimulus” as the Fed introduced each round of “Quantitative Easing,” a “neutral stimulus.”
Twelve years and 400 percent gains later, the “merger” was complete. So investors are now moving from one economic report and Fed meeting to another in anticipation of the “ringing of the bell.”
The problem, as noted above, is that despite the massive expansion of the Fed’s balance sheet and rising asset prices, there has been little translation into broader economic prosperity.
The problem is the “transmission system” of monetary policy that collapsed after the financial crisis.
Instead of liquidity flowing through the system, it remained a bottleneck among institutions and the very rich, who owned “investment wealth.” However, those programs failed to increase the bottom 90 percent of Americans living paycheck-to-paycheck.
The failure of the liquidity drain to restore economic growth can be seen in the table below. While the stock market has returned more than 180 percent since its 2007 peak, that increase in asset prices was 6x real GDP growth and 2.3x corporate income growth. (I have used SALES growth in the chart below because it is not subject to manipulation.)
Since asset prices should reflect economic growth and income, the gap is evidence of a more systemic problem. Of course, the problem comes when they try to reverse the process.
The Great Unwinding
The chart below illustrates the size of the Fed’s current problem.
From the Bear Stearns bailout to HAMP, HARP, TARP, and thousands of other Government bailouts, along with zero interest rates and massive expansions of the Fed’s balance sheet, there were about $10 of monetary interventions for every $1 of economic growth.
Now, the Federal Reserve must figure out how to get markets off “life support” and back to organic growth. As stated by Crooke, the result of the withdrawal of support should be obvious:
“The Fed may be able to break the psychological dependence over time, but the task should not be underestimated. As one market strategist put it: ‘The new operating environment is completely foreign to any living investor today. Therefore, we must anchor to a past that is ‘no longer’ – and walk with open minds.’
“This period of zero rates, zero inflation, and QE has been a historical anomaly—absolutely extraordinary. And it’s coming to an end (for better or worse).
Logically, Pavlov’s great “money experiment” cannot end well. Once the pair’s stimulus is removed from the market, future returns should return to the basic math of economic growth, plus inflation and dividends. Such was the basic mathematics of returns from 1900 to 2008.
In a world where the Fed wants 2 percent inflation, economic growth should be 2 percent, and we can assume that dividends will stay at 2 percent. It’s simple math: 2% GDP + 2% dividend – 2% inflation = 4% annual return.
This is a far cry from the 12 percent returns made in the last 12 years. But this would be the result of the market’s withdrawal from the financial madness years.
Of course, there is a positive result of this.
“If Jay Powell dismantles the Fed and removes the unjustified ability of private capital to hijack and loot the system, it will finally solve income inequality in America,” said Danielle DiMartino Booth, CEO and chief strategist of research firm Quill Intelligence. said on Twitter on December 8.
The bottom line is that fixing the problem won’t be painless. Of course, breaking the bond with any substance is never possible. The hope is that withdrawal does not kill the patient.
The views expressed in this article are those of the author and do not necessarily reflect the views of The Epoch Times.