Plunging Stock Pricess? It's the Fed, Stupid!
You've had a scary seven-year ride on the U.S. Economy Bus Line. The bus went into the ditch once, and it stayed stuck there for 18 months. Since then, it's come close to running off the road several times. There are 319 million other passengers on the bus with you, and this vehicle is your only way forward.
The bus has wifi, your laptop is open, your E-Trade account is up, and you are trying to decide whether to buy or sell U.S. Economy Bus Line shares.
Federal Reserve Chairman Janet Yellen is driving the bus. Economist Paul Krugman is sitting to the left of Ms. Yellen, with Dallas Federal Reserve Bank president Richard Fisher perched on her right.
You're on a narrow road, with sheer cliffs on both sides. Krugman is yelling at Chairman Yellen to turn left, away from the rim of Deflation Canyon, while Fisher is urging her to turn right, to reduce the danger of plunging into Inflation Gorge.
Suddenly, you notice that Ms. Yellen has her hands on the rear view mirror, rather than the steering wheel. Hmmm. Maybe this is why the bus has been swerving all over the road, even though neither Ms. Yellen nor your previous driver, Ben Bernanke, has tried to turn in almost six years.
To your horror, you see the bus start to veer toward the edge of Deflation Canyon. You can't get off the bus, but at least you can put in an order to sell U.S. Economy Bus Line stock. As the bus' wheels near the verge, you also buy the VIX, because your personal fear level is rising fast.
From September 30 to October 15, the Dow Jones Industrial Average fell by 5.3%, while the so-called "fear index," the VIX, rose by almost 55%. Then, over the next two trading days, the Dow rose by 1.5%, while the VIX fell by 13%.
Nothing in the real economy caused, or even could cause, the violent swings in equity values that we have seen recently. As James Carville might have said if he understood money, "It's the Fed, stupid!" Or, to put it more accurately, it's the stupid Fed.
In our little bus fable above, the rearview mirror represents the Fed Funds rate. The Fed Funds rate has been as flat as a board for almost 6 years now, while stock prices, interest rates, commodity prices, nominal GDP (NGDP), and real GDP (RGDP) have been bouncing around wildly.
In other words, our economic bus has been careening all over the road, while our doughty bus driver, Janet Yellen, has maintained a firm, steady grip on a policy instrument that isn't connected to anything.
With $2.7 trillion of excess reserves in the banking system and the Fed paying "interest on reserves" (IOR), the Fed Funds rate has no impact upon either the real economy or the financial markets. It does not matter whether, when, or by how much the Fed raises it.
In fact, since IOR was put in place (on October 6, 2008), quantitative easing (QE) has also been a policy instrument that isn't connected to anything in any determinate way. For the most part, the Fed's three rounds of QE have produced the opposite effects of those that the Fed intended and expected.
So, put simply, the equity markets sold off during the first half of October because investors were afraid-justly afraid-that Janet Yellen and the other members of the Federal Open Market Committee (FOMC) would spend their time arguing over which way to turn the rearview mirror, while our economic bus went off a cliff.
In economic terms, "going off a cliff" equates to a sudden, sharp decline in NGDP, like the one that we experienced starting in late 2008. Because NGDP comprises the final sales revenues of all businesses, the broad stock market indices (like the Dow) are heavily influenced by the market's expectations regarding future NGDP.
While the Fed Funds rate tells us absolutely nothing regarding the future path of NGDP, there are two indicators that tell us a lot. These are the CRB Index* (CRB) and "expected 5-year inflation" (EFYI), which is the difference between the interest rates on 5-year Treasuries and 5-year TIPS.
From September 30 to October 15 the CRB declined by 2.6%, and the EFYI plunged by 11.6%. This showed that monetary conditions were tightening. Reflecting the market's falling expectations regarding future NGDP, the Dow declined by 5.3%.
Then, from October 15 to October 17, monetary conditions eased, with the CRB and EFYI rising by 0.5% and 5.9%, respectively. Higher expected NGDP equates to higher equity values, and the Dow responded by gaining 1.5%. Meanwhile, the VIX eased by 13%, reflecting a declining fear level, as our economic bus veered away from the edge of Deflation Canyon.
Stock market values reflect not only expectations, but also fears. Investors know that our monetary control system is capable of going into a positive feedback loop and crashing, taking the financial markets and the real economy with it. This is exactly what happened in 2008 - 2009 (and in 1930 - 1933, and again in 1937 - 1938). So, when investors see our economic bus start heading toward the cliff, with the FOMC arguing about which way to turn the rearview mirror, they start shorting U.S. Economy Bus Line shares.
One reason that has been put forward for the recent decline in U.S. stock prices is that world economic growth appears to be slowing. Some analysts have expressed fears that "currency wars" may be breaking out. In particular, concerns have been expressed that the ECB may deliberately devalue the euro, in order to raise eurozone inflation and to increase exports.
A look at the values of various world currencies in terms of the CRB Index reveals what is really going on. World economic growth is slowing because all of the major central banks are deflating simultaneously. The only reason that the dollar has been rising against other currencies is that, since mid-2014, the Fed has been the world leader in monetary deflation.
From June 30 to October 15, the value of the U.S. dollar rose by 13.6% vs. the CRB. On the same basis, the values of the euro, U.K. pound sterling, and the Japanese yen went up by 6.4%, 6.3%, and 8.7% respectively. This amounts to worldwide monetary deflation. Monetary deflation is bad for NGDP, which is bad for RGDP, which is bad for, well, just about everything.
The solution is for Janet Yellen to take her hands off the rearview mirror and to put them on the steering wheel. Specifically, the Fed needs to phase out its IOR policy, and to direct its Open Market desk to stabilize the CRB Index at (say) 300 (it closed at 272.69 on October 17, down from 308.22 on June 30).
Stabilizing the CRB would require that the Fed stop trying to manipulate interest rates. It would also force them to surrender control of the size of their balance sheet. The Fed can only target one thing, and the right thing for them to target is the real value of the dollar.
Prosperity is possible, but prosperity requires stable money. With a monetary control system designed to deliver truly stable money (e.g., the modern gold standard system described in H.R. 1576), we wouldn't even need a driver for our economic bus. Our bus would be on rails, on track toward a prosperous future.
*The CRB Index is a commodity price index comprising: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gasoline, and Wheat.
