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Tuesday, August 25, 2015

Why The Fed Should Ignore The Equity Markets

Global equity markets are trading in a disjointed fashion, but there are reasonable arguments for the Fed to ignore the wailing for intervention. Although I do not think a rate hike is needed based on trends in the real economy, if I thought a September rate hike was needed a few weeks ago, it would still be the right response. If the equity market weakness is a sign that the global economy is really keeling over, a couple of rate hikes by the Fed would not make much of a difference at this point.

[UPDATE - 2015-08-27] Another reason to ignore the stock market (that I forgot to mention) is that it bounces up and down in a deranged fashion. A few days after the "end of the world" commentary by equity strategists, everything is apparently back to normal. Another advantage of following credit, and not equities, is that the credit market only tends to break down after a spate of defaults, which are not just transitory mark-to-market events.

The Fed is historically sensitive to trends in the credit markets. This is necessary, as the non-bank financial system of critical importance for funding the private sector in U.S. dollar markets. If credit is not available at any price, the Fed has no option but to intervene. I will admit that I am not particularly close to credit market conditions, but I see no sign that viable companies lack access to credit. (High yield energy companies are being culled, but that is just reality catching up to them.)

The only real danger of a Fed rate hike is that the U.S. dollar will strengthen further. At this point, it is unclear how much further that trend could run. Since a stronger U.S. dollar presumably helps foreign competitors, this should not augment stress overseas, which is where the global weakness is centred.

Roger Farmer On Federal Purchases Of Equities

In "The Next Great Depression" takes a diametrically opposed view. He argues that fiscal policy is ineffective, which I disagree with. (His view is based on the same dubious econometric analysis the IMF was using before the "natural experiment", or more accurately, destructive testing, in Greece. The IMF later admitted that fiscal multipliers were a lot larger than their earlier estimates.) Instead, he echoes the wishes of sell side strategists everywhere.
What can we do? What should we do?
First: Give the Fed the power to buy a value weighted Exchange Traded Fund that contains every publicly traded stock.  Commit to support the ETF by buying stocks. Pay for the shares by  borrowing, or by trading Social Security Trust Fund.
Second: Raise the money interest rate to bring us back to normality and restore normal functioning of monetary policy.
Although equity markets are sensitive to the economy, it is a mistake to assume that they drive the economy. Almost no financing for investment is raised by equity issuance; the only role of the stock market in the modern economy is to act as a means for insiders and private equity holders to sell out their positions. His proposal runs into what is known as Goodhart's Law:
As soon as the government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends.
Goodhart's Law arose because of the similar policy suggestions by Monetarists. Milton Friedman noted that base money growth was correlated with economic activity, and so he made the mistake of assuming that if we could control the growth of the monetary base, we could control economic growth. Professor Farmer is suggesting a similar policy, but just replacing the "monetary base" with "the level of the stock market."

Such a policy would end up being a disaster. If the Federal Government tries defending an untenable level in the stock market, it would end up having to buy a significant portion of it. It would likely capitulate, much like the Swiss National Bank's euro peg, causing spectacular notional losses on the equities it purchased when defending the market level.

But even if it appears to work in the short term, the value of the stock market as a signalling mechanism would be broken. If a recession is imminent, credit investors will attempt to exit financing failing companies, and an artificially stabilised broad equity index will not do anything to prevent that exodus.

Longer term problems would fester. Would the government take its responsibility as a shareholder seriously, and start voting in what it sees as the national interest? Will the government attempt to exit its position? How will it determine what is the "correct" level of the stock market to defend? How will it keep its equity investment strategy from being front run? None of these questions have very satisfactory answers.

(c) Brian Romanchuk 2015


  1. The Goodhart's Law link takes us to the same Roger Farmer post..


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