The Federal Reserve’s extraordinary policy moves over the last 12 years have marched arm-in-arm with the biggest bull market in Wall Street history.
But the central bank’s economists say the two really have little in common.
As part of the ongoing discussion Fed officials are having about the effectiveness of past policy and the proper path forward, staff members last month presented their findings about the impact that low interest rates have had on asset prices, which generally refer to things like stocks, corporate debt and commercial real estate.
Their conclusion: “The available empirical evidence suggests that the effects of changes in policy rates on asset prices and risk premiums tend to be modest relative to the historical fluctuations in those measures,” according to minutes released Wednesday from the Jan. 28-29 meeting.
That’s contrary to the conventional Street wisdom which ties the low rates and money printing to a market bull run that is less than a month away from its 11th anniversary.
But the analysis also reflects a tightrope Fed officials are trying to walk in which they want to keep policy accommodative enough to maintain the economic expansion while not fueling bubbles.
“What they’re saying is rates have affected the economy, but what they’re not doing is causing the rampant speculation that you saw in the late ’90s,” said Doug Roberts, head of Channel Capital Research. “It could happen, but right now they’re trying to prevent it.”
Still, the idea that the relationship is tenuous between ultra-easy policy — zero policy rates that prevailed for seven years and nearly $4 trillion worth of quantitative easing — and a more than 400% rise in the S&P 500 is a tough sell.
Putting blinders on
Every time the Fed has tried to tighten policy, the markets have recoiled and the Fed has relented.
“They think that valuations are justified because rates are so low,” said Danielle DiMartino Booth, who was an advisor to former Dallas Fed President Richard Fisher and now is CEO of Quill Intelligence. “At the risk of saying it’s different this time, I think the Fed is not factoring in its own policy in its risk premium calculus.”
Indeed, St. Louis Fed President James Bullard told CNBC on Friday that he is not very concerned about where the market stands. The S&P 500 is trading at 19 times forward earnings, compared with the 10-year average of 15, about a 27% premium.
“We watch financial stability issues and bubble-type issues very carefully,” Bullard said during a “Squawk Box” interview. “I think that the conventional wisdom is valuations look high, but not at this level of interest rates. And so to the extent that you think this level of interest rates is probably the future, which I have been arguing, you’re probably OK for now.”
But Booth said that adjusting earnings for the historically low interest rate environment actually does put valuations around the dot-com bubble era of the late 1990s.
She credits Fed Chairman Jerome Powell with trying to stay ahead of runaway asset prices but said current policy doesn’t leave enough room for the central bank in case of an economic downturn.
“It doesn’t really work well to put blinders on. That’s what it feels like officials are doing,” Booth said. “With interest rates so low, you wonder what the next shock to the system will be. They’re running out of ammunition.”
Powell tried to guide the Fed back to a more normal state of affairs regarding interest rates, but markets recoiled and he was forced to backtrack. Four rate hikes in 2018 sparked a wave of selling on Wall Street, and the Fed responded with three cuts last year and a resolve in 2020 to hold policy steady.
If anything, markets are expecting more rate cuts rather than increases.
“The Fed has become the enabler for the markets,” said Quincy Krosby, chief market strategist at Prudential Financial. “They wanted to raise rates in 2019, but they didn’t. They saw within a couple of weeks what was happening. Then what they did was create this ‘buy on the dip’ mentality. You’re never able to get off it. That’s the dilemma for this policy.”
‘The news is good’
The Fed also tried to undo at least some of the QE bond purchases it conducted during and after the financial crisis by allowing a capped level of proceeds to roll off its balance sheet each month rather than being reinvested. That, too, prompted a market recoil, and the Fed is again building up its holdings by buying short-term Treasury bills in an operation it insists is not a fourth round of QE.
There is an ongoing debate about whether the current balance sheet expansion, different though it may be, is helping push stocks higher.
Fed officials contend that the most recent leg up for the market has been more about the dovish rate stance members adopted in 2019. Others have argued that bond buying, if nothing else, acts as a signaling device for the market that the Fed is going to keep policy accommodative. When that stops, market expectations change.
Markets should be paying less attention to this balance sheet expansion, said Ethan Harris, global economist at Bank of America Global Research. Despite a close correlation in the QE operations and the rise in the stock market, the Fed is now just acting to keep liquidity flowing in the banking system rather than to promote larger economic objectives.
“Outside of the money markets, we suggest that investors put very little weight on the Fed’s balance sheet actions,” Harris said in a note to clients. “Focus instead on interest rate policy. Here the news is good: the Fed is clearly taking no risk of recession and will repeat last year’s easing if the economy falters.”
Officials said at the January meeting that they will continue to monitor financial risks from their policies. Minutes said the members noted “elevated” asset valuations, and pointed out that business debt to GDP was “high by historical standards.”
“We have a world where equity valuations are what they are,” Fed Vice Chairman Richard Clarida told CNBC’s Steve Liesman in an interview Thursday morning. “I think the overall picture is that financial stability risks are moderate. But we are closely monitoring the financial system, as we should.”