The Fed Still Holds Up Asset Prices, Despite Rate Hikes

The Federal Open Market Committee (FOMC) released its latest statement on monetary policy on December 13, 2017.  As expected, the target federal funds rate was hiked by a quarter percent.  The federal funds rate target is now in the range of 1.25% to 1.50%.

This was widely expected, and therefore, the markets did not react negatively.  Stocks were largely flat or up, and gold was up for the day.  The rate hike was already priced in.

When we talk of rate hikes now, it has almost nothing to do with the money supply.  While the Fed is continuing its program of rolling off assets at around $10 billion per month (a very small percentage of the monetary base), this is not directly correlated with the hike in the federal funds rate.  (The roll off rate will increase to $20 billion starting in January.)  Since the commercial banks still have huge amounts of excess reserves, the Fed increases the interest rate it pays to banks on their reserves in order to hike its target rate.

On the same day as the Fed’s statement, the latest CPI numbers were also released.  The CPI was up 0.4% in November, but the CPI less food and energy was only up 0.1%.  The more stable median CPI was up 0.2% and stands at 2.3% year-over-year.  Price inflation may not be as tame as what the Fed makes it out to be, but it isn’t roaring out of control either.

The place where we continue to see high price inflation is in assets.  These prices are largely ignored in the government’s statistics in calculating consumer price inflation.  The problem is that consumers do buy houses, stocks, fine art, and even Bitcoin.  While these are considered assets, they still have prices, and people spend money on these things.

For those who follow Austrian school economics (free market economics), it may be curious why asset prices continue to rise.  The Fed is hiking rates and deflating its balance sheet (albeit slowly).  The Fed stopped QE3 over 3 years ago now, yet the bubbles have yet to pop.

First, it does take time for things to play out.  Just as an inflation in the money supply does not hit instantly, a deflation also doesn’t hit instantly.  It takes time for the previous malinvestment to be exposed.

Even more importantly, I believe that this bubble is taking longer because of the financial crisis nearly a decade ago.  More accurately, I believe it was the Fed’s response to the financial crisis that is holding up this market.  And it is possible that it could make it last longer than what seems possible.

The Fed’s reaction to the crisis in 2008/ 2009 was unprecedented.  It was probably even a surprise to those who advocate massive intervention in the marketplace.  The Fed bailed out major banks and financial institutions, and it nearly quintupled the adjusted monetary base.  This would not have been believable if you had predicted this in 2007.

The Fed acted so aggressively that there is even more of an implicit guarantee than there was before.  At this point, it is even hard to use the word “implicit”.  It is almost a certainty that the Fed would act aggressively again if the bottom fell out.  In other words, the moral hazard has increased.

Stock investors and real estate investors know that if things turn ugly, the Fed will quickly step in and try to revive things.  If the Fed quintupled its balance sheet before, why can’t it do it again?  As long as the Fed is willing to step in with an aggressive easing (i.e. digital money printing), then there is a lot less to fear.

The same goes for bond investors, or even more so.  It is possible that stocks could fall despite more money creation from the Fed, particularly in the short run.  But for bond investors, they know that the Fed will create money by buying assets.  And when those assets are bonds, then there really isn’t much to fear as long as price inflation remains relatively tame.

The Fed isn’t holding down market interest rates and propping up asset prices by its actions.  It is doing these things because of its previous actions and the anticipation that it would do so again.

For that reason, it makes it difficult to short the market right now.  The boom and bubbles are unsustainable, and they will eventually turn to a bust.  But things could go on for a while longer because of the Fed’s willingness to step in right away.

The Fed will ultimately not be able to stop the implosion, but it does have the ability to kick the can down the road.  We just don’t know how much road it has left.

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