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Powell is Nervous

On December 15, Federal Open Market Committee Chairman Jerome Powell announced a doubling of its balance sheet taper. While this decision was largely anticipated by the markets, as Powell recently testified before Congress the FOMC would likely end its balance sheet taper a few months early, Powell seemed a bit nervous. The Fed Chair has every reason to be afraid, as the equity markets are very sensitive to balance sheet tapers and reductions.

The Federal Reserve’s dual mandate, as established by Congress, is to promote maximum employment and price stability, not to prop up asset prices. Every time equity prices experience a significant decline, the Fed tends to run to the rescue with lower interest rates or more Quantitative Easing. The Fed’s behavior suggests and implies the Fed is far more concerned about stock prices than the economy.

Former Fed Chair Alan Greenspan was one of the first Fed Chairs to focus on the presumed wealth effect created as a byproduct of easy monetary policy. In February 2000, Greenspan testified before the Senate Banking Committee to defend his decision to maintain easy monetary policies despite a growing concern from policymakers that the Greenspan-led Fed was inflating a massive asset bubble.

The ensuing popping of the dot-com bubble would vindicate the concerns by the Senate, but that validation did little to stop the economic destruction caused by a more than eighty-percent crash in the Nasdaq-100 from March 2000 to October 2002. GDP growth peaked in the second quarter of 2000 at 7.6% and bottomed in the fourth quarter of 2001 at 2.2%. The unemployment rate bottomed at 3.8% in April 2000 and later peaked at 6.3% in June 2003.

Despite former-Fed Chair Greenspan’s attempt to slow the rate of increases in the Consumer Price Index and engineer a soft landing of the economy by slowing raising the effective Federal Funds Rate from 4.63% in Jan 1999 to 6.53% in July 2000, he successfully popped the asset bubble he created. The wealth effect Greenspan worked so hard to create that helped fuel economic growth, ended in a devasting recession that would take the economy three years to recover from and the Nasdaq-100 thirteen years before it regained its prior peak.

Once again, the Fed has inflated a massive asset bubble through overly loose monetary policy. By keeping interest rates low for an extended period, it has incentivized consumers and corporations to borrow at ultra-low rates to buy assets yielding a higher return. The longer the Fed holds rates at artificially low levels, the more speculation seems to run rampant as investors chase equity prices higher by borrowing record amounts of money on margin to buy stocks.

With consumer price inflation running rampant, the Fed is forced to contain inflation through monetary policy by removing its accommodative policy. History is very unfriendly to the Fed when it attempts to scale back its easy policies or even worse tighten monetary policy, as asset bubbles tend to burst. Both the dot-com and Great Financial Crisis were in part caused by the Fed tightening monetary policy.

While the FOMC suggested it might be appropriate the raise the Federal Funds Rate later next year, which would begin to tighten monetary policy, the Fed is still maintaining an accommodative policy by reducing its asset purchases. Prior balance sheet tapers have not been friendly to the Fed who hopes to quietly promote financial stability by maintaining elevated asset prices.

After all, when American’s feel wealthy, they tend to spend more. When they believe their wealth is going to continue increasing, they tend to borrow money and spend even more. Through the combination of an increase in borrowing and spending, inflation and economic growth can be sustained.

By removing accommodative policy, the Fed runs the risk of destroying or at the very least significantly impacting the asset bubble they worked so hard to create. When looking back at the history of balance sheet tapers or reductions, it does not look good for the Fed.

On October 29, 2014, the Federal Reserve announced the end of Quantitative Easing 3, which in effect was an abrupt taper of its balance sheet. While the stock market did rally into mid-2015 following the Fed’s announcement, by late June 2016, stock prices were no higher than they were at the time of the Fed’s announcement. Nearly two years of stock returns were lost at the hands of the Fed and years later when the Fed announced a reduction in its balance sheet, stocks would be adversely affected again.

On June 14, 2017, the Federal Reserve announced details for its plan to normalize its balance sheet by reducing the U.S. Treasury and Mortgage-Backed Securities held on its balance sheet. In October 2017, the monthly plan to reduce its balance sheet was initiated. Once again, stock prices rose following the beginning of the normalization plan but by April 2020, more than two years later, stock prices were unchanged.

As Fed Chair Powell stood at the podium to announce to the world the end of the latest iteration of Quantitative Easing, he had every reason to be nervous. If history is any guide, the end of this post-pandemic bull market in equities is soon to end. With any luck, asset prices will remain elevated but without further accommodative monetary policy, the asset bubble is likely to burst.