Finance NewsOther Finance

Federal Reserve Is Now Hostage To the Stock Market

The Fed will continue to be accommodative of the market for fear of a sell off

For the past three weeks, investors have been eagerly waiting for an indication by the Federal Reserve that an interest rate cut would be imminent in the very near future.

Fed chairman, Jerome Powell, discounted the good economic news, stating that the positive factors, continuing low inflation, which has consistently been below the Fed’s 2% target rate and low unemployment, were insufficient reasons, in his opinion, to offset the unforeseeable risks a rupture in the trading relationship between China and the U.S. would have on the economy. Since a trade agreement with China now appears rather remote, the Fed must take into account risks to the economy that were not as imminent as they were two months ago.

Shortly after Powell’s announcement that the Fed was leaning towards a rate cut after its July 31st meeting, investors began switching over to riskier assets, which they believed had the blessing of the Fed.

After Powell’s comments, like spoiled children, investors acted as if a rate cut of 50 basis points was somehow foreordained. Indeed, judging by some of the articles in the Wall Street Journal, Barrons and other financial publications, some investors were talking as if it was their divine right to be coddled by the Fed and receive a hefty rate reduction. In late June, the fed funds futures market put

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the probability for a ½ point rate cut at 45%. This nonsense was quickly dispelled, but it is an indication of investors’ unrealistic expectations in terms of how obliging the Fed should be towards their desires to continue to ride the tail- end of the ten-year bull market.

The Fed has been reluctant to raise rates for fear of inducing a slowdown in consumer spending that has occurred every time it signals a rate increase or if there is a perception it is not acting quickly enough in adjusting its neutral rate when economic conditions rapidly change.

Today, the spending habits of many consumers are linked to the changing status of their net worth. The number of consumers with 401k an IRA retirement accounts, has skyrocketed over the past thirty-years. When the stock market goes down, it doesn’t just impact the 1% income bracket, it affects a fair number of American households whose retirement accounts are invested in the market.

When retirement accounts are down, it can make some consumers feel their disposable income is down as well.

The problem with the Fed’s posture, is that it encourages investors to purchase risky asset classes, with the expectation, not entirely unwarranted, that the Fed has their back, when conditions turn for the worse. Investors feel that because of the historically elevated importance of the stock market on rate policy, the Fed will never raise rates, when it might cause a massive drop in risky asset classes, such as junk bonds.

Powell has clearly indicated in the past, that an inverse bond/equity relationship leading to asset class mispricing, can create a dangerous bubble that can lead to economic downturns. He now seems to have let his concern about the dangers of a boom bust cycle fall by the wayside. Though Powell may continue to warn of the dangers of holding a disproportionate amount of risky assets, he understands, in terms of monetary policy options, his hands, currently are tied .

So, while Powell may warn investors that the Fed will not bail them out for making poor investment decisions, his counsel is given, with a wink and a nod.

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