The prospect of a Russian invasion of Ukraine sent markets tumbling, heightening inflation fears that have built up over the past few months. The S&P 500 is trading 10% below its recent all-time high, while the Nasdaq is down more than 16%.
Markets have been inflated for years by very accommodative monetary conditions in which interest rates have been ultra low and central banks have “printed money” in the form of quantitative easing (QE). But an additional factor that has encouraged investors to pour so much money into the markets is the so-called “Fed put”.
It’s the idea that the US Federal Reserve (and other central banks) won’t let markets fall past a certain threshold – say 20% to 25% – before springing to the rescue with rates lower and more QE.
The debt of the global financial system is such, according to logic, that the markets should not be allowed to fall any further. A deeper drop could trigger a chain reaction of bad debts that could destabilize the biggest banks and cause a crisis that would make 2008 soft.
Known as a “put” in reference to a financial instrument options traders buy to hedge against falling markets, the argument is that the markets are actually a one-sided bet.
Admittedly, the S&P 500 has multiplied by six since 2009 and the Nasdaq by 12, as central banks have eased monetary conditions on several occasions. Even the underperforming FTSE 100 rose by two-thirds over the same period.
We would say, however, that the Fed put no longer exists. Let’s explain why.
Putting into action
The idea emerged when Alan Greenspan was chairman of the Federal Reserve. Beginning with the Black Monday crash of the fall of 1987, Greenspan gained notoriety for cutting the federal funds interest rate to improve investor sentiment when markets fell significantly. This is a big change from the Fed’s previously very slow and cautious approach to changes in the business environment.
When Greenspan cut aggressively after the dot-com crash of the early 2000s, it helped inflate the US subprime housing bubble that precipitated the 2007-09 crisis. During this crisis, the response of the Fed – then under Ben Bernanke – was again to lower rates and also to increase the money supply through QE.
This extra money has encouraged financial institutions to lend to businesses and consumers to pull the wider economy out of recession and to lend more to merchants so they can invest it in the markets.
Federal Funds Rate 1972–Present
The effect of this QE has been to expand the Fed’s balance sheet (in other words, its assets and liabilities) after years of stagnation to around US$1 trillion (£733 trillion) to peak at US$4.5 trillion in 2014.
The Fed then very slowly began to unwind these holdings and raise the fed funds rate from 0.25% to 2.5%, but after a sharp 20% drop in the S&P 500 at the end of 2018 (and also a price drop government bonds), it started cutting rates again.
The Fed continued to unwind QE in the first half of 2019, bringing its balance sheet below $4 trillion. But it reversed later in the year after a spike in the crucial ‘repo’ rate at which banks lend funds to each other overnight, raising concerns about the prospect of another panic. 2008 styling.
In March 2020, as the global economy came to a halt in the face of the Covid pandemic, the Fed then went into full bailout mode. He announced the most aggressive quantitative easing program yet to support the economy, and the toll swelled to nearly $9 trillion by the end of 2021.
Federal Reserve balance sheet
The result of all this easing has been a huge spike in asset prices – not just stocks and bonds, but also real estate. Although it is difficult to estimate the effect, the richest 10% in the United States now own more than 60% of the assets, while the poorest 50% own less than 6%.
The situation now
The recent declines in stock markets (and bond markets) are occurring while the US economy is doing well. It increased by almost 6% in 2021 despite the pandemic. The labor market is robust and low-skilled workers are finding new opportunities with higher wages.
Yet consumer confidence is low, partly because of inflation. Consumer prices in the United States rose 7.5% in the 12 months to January 2022, the strongest since the early 1980s, while the situation was similar elsewhere, including in the United Kingdom -United.
The big fear is that workers will start demanding equivalent wage increases in response. This could cause a wage-price spiral in which producers raise their prices further to pay higher wages, sparking new wage demands, etc., essentially making inflation a longer-term problem.
The Fed is tightening monetary conditions in an attempt to control inflation: reducing QE to end in March with a view to starting balance sheet shrinking later in the year, and signaling that the federal funds rate will begin to increase from its current level. 0.25% in March.
When central banks tighten in this way, it tends to cause economic slowdowns and recessions. With the prospect of less QE money available to traders, this helps explain why markets have fallen. The question is what will happen if the markets fall further: will the Fed and other central banks continue to tighten or will they reverse?
There is a wide variation in interest rate expectations, indicating that no one is sure. In our view, the Fed and other central banks should tighten quite aggressively, in line with what current Fed Chairman Jay Powell has signaled.
This time is likely to be different for several reasons. Inflation was never a problem in the days of the Fed put. This risks seriously damaging the credibility of the Fed, not to mention impoverishing ordinary people with potentially serious political consequences.
The financial system is also very different from that of 2008. While part of the problem during the global financial crisis was that banks had too little capital to protect themselves, the system is now better regulated.
At the same time, the pandemic has also been a very different economic crisis than other recent crises. The most recent crises, including those of 2007-2009, were caused by problems within the financial system – what economists call an “endogenous shock”.
Something external like a pandemic is an “exogenous” shock, and these tend to be quickly absorbed by healthy financial systems, with growth resuming smoothly once the disruption is over.
Raising rates and ending QE should be much more achievable with today’s sound and well-functioning financial system. It is therefore much less likely that central banks will save financial markets from a crash by reversing the tightening for fear that the system will not recover.
How far markets fall as the economy slows depends on many factors, including the Ukraine-Russia conflict and the path of inflation. But with the Fed arguably out of the picture, everyone from pension holders to retail investors should be very careful.
Edward Thomas Jones is Lecturer in Economics at Bangor University and Yener Altunbas is Professor of Banking at Bangor University
This article is republished from The Conversation under a Creative Commons license. Read the original article.