The Stock Market: The Federal Reserve Dilemma

Katie Martin has produced a very interesting article in the Financial Times that I think puts the actions in the stock market of the previous six months or so into a better perspective.

Ms. Martin incorporates her discussion within the context of “bear market rallies.”

In the previous six months or so, the U.S. stock market has experienced several rallies.

The rallies have always ended with a following decline.

The overall movement in the market, consequently, was down.

As can be seen in the chart, the stock market just went through another “rally” followed by a fall.

This movement, Ms. Martin writes, “can be painful.”

They may just turn out to be “head=fake moments.”

She attributes all this volatility to the fact that “some investors” grabbed the wrong end of the stick from comments by Federal Reserve chair Jay Powell….”

Where Is The Economics In All Of This?

“Where is the economics in all of this?” you may ask.

Well, that is a very good question.

And, this is what I have been writing about all summer and into the fall.

The “market” seems to be responding primarily to Jay Powell and what they perceive the Federal Reserve to be doing.

Look at this past week.

On Wednesday, investors believed that the Federal Reserve would raise its policy rate of interest by 75 basis points.

At 2:00 pm on Wednesday afternoon, the Fed announced that the Federal Open Market Committee had raised its policy rate by 75 basis points.

But, what happened around this change?

The Fed “raised its benchmark interest rate by 0.75 percentage points again, as expected, and Powell did suggest further rate rises might be smaller.”

Stock prices rose!

“But, he also pulled the step ladder from under climbing stocks by saying rates would probably end up at a higher place at the end of this process than previously thought,” Ms. Martin writes.

Stock prices fell.

And, there you have it.

No economics.

Just Federal Reserve talk.

And, this is where we are as far as the stock market is concerned.

The Lesson

When we move into a period when almost all of the attention of investors is on the Federal Reserve, we are in a place we should not be.

Early in my career, I learned that when the focus in on the Fed, something is wrong. The Fed has lost control of things and investors don’t know what to do.

Here, we have the story of the spread of the Covid-19 pandemic, the recession that followed it and the “fear” within the Federal Reserve that they could not let things get “out of hand.” The Fed could not allow a financial collapse and so it poured mountains of liquidity into the financial markets and the “collapse” was avoided.

Now, what do we do with the “mountains of liquidity” that remain within the financial system.

Oh, and by-the-way, we are now experiencing fairly rapid inflation that has resulted from all this liquidity being around.

Whoa! We have too much liquidity hanging around from the Covid-19 threat and, now, we have too much inflation hanging around from all the liquidity that has been pumped into the financial system, what do we do?

So, the Fed continues to hold monetary conditions tight, inflation comes down, and now the stock market actually does have reason to rise.

Currently, what is the underlying fear moving forward?

Ms. Martin answers that .

“Asset managers have a huge amount of financial firepower stashed away in cash that they are itching to deploy. that means that when the real recovery does start, it will be dramatic and lasting.”

“October appears to have provided yet another mirage. It is worth exercising extreme caution next time around too.”

In other words, we still may not be out of the financial strains creating earlier by the Federal Reserve.

That is, the emphasis will continue to be focused upon the Federal Reserve and what it is going to do, and not on the underlying economic conditions.

The Federal Reserve has created this dilemma. One way or another the Federal Reserve is going to have to get itself out of the headlines.

This, however, could be very painful.