The Fed is Playing with Fire

 

In 2020, it seems as if everything has been unprecedented. We have had a worldwide pandemic, an economic crisis, and the largest protests and riots in US history. We also had an election, that, of course, included unprecedented events and clams following election night. It is all truly exhausting.

With the laundry list of notable events that occur this year, you would be more than forgiven for not paying any particular attention to US monetary policy. As comparatively insignificant as this issue may seem, it is one of the few novelties of 2020 that will extend far beyond this year and have consequences for potentially decades to come.

First, a few graphs:


Image for post

This is a graph of the M2 Money Supply. There are two main ways of measuring the money supply, M1 and M2, with M2 being the most broad measurement of the two. M2 includes everything included in M1 (Cash, demand deposits, and traveler’s checks) as well as other very liquid assets, such as savings accounts, mutual funds, and time deposits.

The graph above paints a fairly simple story. The money supply rises over time, with more money being printed in the aftermath of the 2008 crisis. However, I am sure that the reader has noticed the very concerning spike in the money supply that starts near the beginning of 2020.

This, of course, corresponds with the start of the COVID-19 pandemic. If you do the math, that increase in the money supply is equal to roughly a 23% increase in the money supply over the last year alone.

It is concerning, to say the least, that the money supply has been increased by such a large amount in such a short amount of time. However, this situation begs the question: why aren’t we seeing any inflation? After all, it is common sense that increases in the money supply should result in increases in prices. Inflation is a very observable phenomena.

The answer is that there are real inflationary effects, just not where you might expect to look. The inflation from the Fed’s ballooning of the money supply is not found in grocery stores, but in the stock market. Whenever the Fed goes out to buy U.S. Government Bonds with newly printed money, it usually doesn’t buy them from everyday people. Instead, they usually buy them from investment firms or other large enterprises. This companies tend to invest money in the stock market, so any new money entering the market is likely to hit the stock market first, before it goes anywhere else.

Thus, we can expect that whenever there are large increases in the quantity of money, we would expect the stock market to be the first to see its prices increase. All it takes is a single look at the stock market to see that we are watching the first effects of this inflation in real time.


Image for post

This is the Dow Jones Industrial Average, often seen as the best indicator for the stock market as a whole. This graph tells us a very interesting story, one that is revealing about the actions of the Federal Reserve over 2020:

Throughout 2019, the Dow Jones did quite well, breaking new highs for the index at several points in the year. At the start of 2020, it was among the highest peaks that the Dow Jones had ever reached. Naturally, there was quite a bit of optimism about the stock market as a whole.

Then, it came crashing down when COVID-19 pandemic started to sweep the world. As nations began instituting lock downs and shutting down businesses, the Dow Jones began to plummet, losing almost all the progress it had been over the last four years.

In response to these developments, the Federal Reserve took swift actions. For the last several years the Fed had been looking to slowly raise its target interest rate after keeping at or near 0% for years following the 08' Financial Crisis. All notions of keeping rates high was immediately thrown out the window as the Fed announced it would cut its rates down to 0%. Along with this, the Fed announced it would undertake a $700 billion of quantitative easing.

Very shortly afterwards, the Dow Jones starts to recover. Eventually, this progress upward, although not wholly uniform, has lead us to the months of November and December, where the Dow Jones is hitting all-time highs. Mind you, these are not the highest points it has reached since the start of the pandemic, but the highest points it has ever reached in its 124-year history.

This is the story this graph tells. It is a story that makes no sense.

It is amazing how there is no correspondence at all with the economic realities of the world and the stock market which it is ostensibly based upon. During the months of April and May, when the world was being hit hard by the pandemic and lock downs, the stock market continued to rise. Why?

During the Summer and Fall months, the Dow Jones continues to rise, even as there is still no end to the pandemic in sight. There are some areas relieved from the lock downs, but many countries and areas remain closed. Despite all these facts, the Dow Jones begins to recover, even at or near the levels it attained before the start of the pandemic. Why?

Even now, as record case and death numbers come in daily, and the world suffers the worst throws of the COVID-19 crisis, the Dow Jones hits all-time highs. Even as businesses, even those that managed to survive the first round of lock downs, begin to fail and shut their doors, the stock market seems to be doing fine. Why?

Of course, there has been cause for optimism at several points during the pandemic that might explain the rises we see in the Dow Jones. During April and May, there was belief that perhaps everything might be over by the fall. However, this was soon shown to be false. However, the stock market never went down after this realization. During the fall, it seemed as if the worse days were over and life may soon return to normal, however the months of November and December have shown this to be false. However, the stock market continued to grow.

With the announcements of successful vaccines for COVID-19, the stock market has understandably seen growth in the wake of these announcements. However, does does not explain any of previous growth over the last months. Even so, this would be a cause for optimism

Prima facie, there appears no rational explanation for the growth we see in this graph. That is, until we see this graph through the lens of inflation. With he Federal Reserve’s program’s announced in March, along with its relief efforts since, we would expect lots of money to be created. If a large percentage of this new money was put into the stock market, as we would expect from our analysis above, then we would expect increases in stock prices, regardless of surrounding economic situations.

If the Fed is really inflating the stock market, what consequences will this have, if any? If the stock market is push up to an artificially high point, then stock prices are much higher than the market would normally place. This is often referred to as a “bubble”.

During a bubble, prices are pushed up beyond a reasonable point purely because of cheap money that artificially simulates investment. Cheap money can’t go on forever without significant inflation, so eventually the printing presses stop. When they stop, the source of the bubble is gone. At this point, the bubble pops, as the fuel for the bubble is gone. Prices begin to fall and return to normal levels.

When the bubble is popped, it causes widespread economic damage. Investments turn out to be busts, people lose jobs in industries were demand has now dried up, and unemployment begins to increase at a rapid pace. Everyone suffers in some way, and nobody escapes unscathed.

We are seeing the bubble formation process right before our eyes. It is the same scenario that played out in 1929 and 2008. Both of those economic depressions featured monetary policy that promoted low interest rates and cheap money. This predictably lead to bubbles in stock prices. We did not learn from the mistakes of the past, and as such, we are now doomed to repeat them.

The crash for the bubble is coming. How bad the crash is depends on how long we keep the bubble inflated. As more and more investment is poured into the artificially high stock market over time, the harder the crash will be. If we stop the easy money now, we will escape with a much smaller crash. If kept up for longer, we will be sentenced to a much harsher fate.

Over the last year, the Fed has been playing with fire. The only question left is how badly we will be burned.

Comments

Popular Posts