Is It Time to Ignore the Fed?

All eyes are on the Fed. When will it begin to raise interest rates? Some say next summer. Others think sooner, in the first quarter of next year. A few Fed governors insist that will be too late, that the Fed needs to act before year-end.

Analysts hoped some hints could be gleaned by reading between the lines of Fed Chair Yellen’s speech in Jackson Hole on Friday morning, or perhaps from nuances in her tone of voice.

That is how much investors, who despised the Fed and railed against it and the rest of the government during the 2008 financial meltdown, have come to trust the Fed to know what it’s doing over the last six years. And it has not let them down.

Each time the economy faltered in its recovery from the 2008 meltdown, the Fed came in with additional stimulus. Sometimes, as in 2011 and 2012 it was just in the nick of time, as the stock market became nervous waiting, and rolled over into corrections, a decline of 19% by the S&P 500 in 2011.

However, those six years were one-directional for the Fed. Its decisions were limited to when it needed to apply more pressure on the stimulus accelerator and how aggressively. It has always been quite proficient at that once the economy is in recovery mode.

Now it has begun a reversal of monetary policy.

With its assessment that the economic recovery is sustainable on its own, it has lifted its foot off the accelerator, dramatically tapering back QE stimulus since January, planning to have it gone by October.

It is now debating its next step, when to begin raising interest rates from the record lows near zero.

This is a different situation than that of the last six years, and based on the Fed’s history at monetary policy turning points, it is of extreme importance to investors.

The history is quite clear going all the way back to 1929, when changes in monetary policies are blamed for making the 1929 market crash and Great Depression much worse than they needed to be.

Later, in the 1970’s, the Fed was so far behind the curve it had to repeatedly raise the Fed Funds rate until it finally reached record highs above 18%. (During that 17-year period there were five bear markets).

[Must Read: The Interest Rate Conundrum: Flight to Quality or U.S. Slowdown?]

In the modern era, in 1987, newly appointed Fed Chairman Alan Greenspan initiated a series of rate hikes to level off economic growth. The result was the 1987 market crash.

As the bubble formed in the stock market in the late 1990’s, the Fed did not begin raising interest rates to cool it off until August 1999, and did so in timid quarter point hikes until November 2000, six months after the bubble had popped and the severe 2000-2002 bear market had begun.

It was not until February 2001 that it finally said ‘whoops’ and began cutting rates in an effort to bring about recovery, and was way too slow and too late again.

It then continued to cut rates until May 2004, well after the 2001 recession ended and the powerful 2003-2007 bull market was underway. Only then did it begin to raise rates back to normal. By then the continuing easy money policies had the next crisis, the housing bubble, forming.

At the next top, the Fed did not begin cutting rates to re-stimulate the economy until 2008, with the 2007-2009 bear market, the 2008 financial meltdown, and the ‘Great Recession’ already underway. Meanwhile, Fed Chairman Bernanke said in January 2008 that, “The Federal Reserve is not currently forecasting a recession”, and as late as June 2008 said, “The risk that the economy has entered a substantial downturn appears to have diminished over the last month or so.” Behind the curve? Well, yeah.

The Fed is now in policy reversal mode again, for the first time since the 2007-2009 meltdown. It will be a much greater challenge even than any in the past when it performed so poorly.

This time the Fed is in uncharted waters. Never before has it taken $trillions of mortgage-backed securities off the balance sheets of banks onto its own, or loaded its balance sheet with $trillions in Treasury bonds to hold yields and interest rates down. Never before has it had the Fed Funds rate cut to zero.

Investors, aware of the Fed’s failed timing at its previous policy reversals, might want to move away from the approach of the last six years, of monitoring the Fed’s every word, and focus more on the conditions that moved the market at previous market tops. Those conditions moved the market contrary to the Fed’s confidence each time that it was on top of the situation.

They included high stock valuations and extremes of investor euphoria that had insiders selling heavily and smart money billionaires concerned about the risk and issuing warnings, even as the Fed debated each time about what it should do, if anything.

The Fed is telling us we are not in the situation of the last six years, when the degree of stimulus was its only decision, but in a period calling for a reversal of its monetary policies.

Food for thought.

About the Author

Sy Harding

Editor
Street Smart Report