The stock market generated returns erratically over this period, as it always does. Fed actions have often been put forward as an explanation for this short-term volatility. However, evidence points to investor emotional overreactions as a more likely explanation.
However, the events of 2008 provided a glaring exception. The Fed chairman at the time, Ben Bernanke, made the horrible mistake of allowing Lehman Brothers to fail. Immediately, the federal funds market ceased to function, shutting down the economy’s financial railroad. The Fed failed as the lender of last resort.
To save the economy, the Fed injected massive liquidity into the banking system. I refer to the resulting excess reserves as the “Bernanke Mistake,” which haunts us to this day. If only he had initially acted as the lender of last resort, the great recession would have not been so great.
Busting Fed Myths
So now that we’ve busted a few of the myths surrounding the Fed and its impact, here are a few more:
Myth 1: Contrary to conventional wisdom, the Fed does not control interest rates. The Fed can set rates for a small fraction of financial transactions, but markets determine rates on the vast majority. The Fed attempts to influence where rates go, much like the Wizard of OZ with his elaborate set piece, but markets have the final say.
Myth 2: As a corollary to Myth 1, it is believed that the “Fed raising rates” hurts stock returns. Beyond rejecting the Fed setting interest rates, evidence reveals that most often rising rates beget higher stock returns. This is because rising rates are the consequence of stronger economic growth and this growth more than offsets the negative impact of rising rates on stock returns. Growth trumps rising rates when it comes to stock returns.
Myth 3: It is widely believed recent economic growth and stock returns are a consequence of Fed-supplied liquidity and not underlying economic strength. The initial Bernanke liquidity surge was critical to saving the economy. But over the last three years the Fed has systematically reduced excess reserves, yet the economy and stock market continue to grow. We are no longer in a liquidity-driven market. The Bernanke boil has been lanced and we are doing fine as it drains.
Ignore The Fed
The Fed plays a critical role in maintaining the playing field upon which all of us pursue economic activities. It is important to note that economic growth and the resulting market returns are the result of our collective efforts, with the Fed playing a supporting role. But since it is hard to identify a single economic “quarterback”, we gravitate to the Fed and project power and influence on them well beyond what is the case.