The Fed is currently having a moral crisis over pulling back credit support that is being mistaken for an identity crisis. Let me explain.
The Federal Reserve was established to manage the nation’s money supply and banks. The baking system uses the Fed’s balance sheet and discount window, while the Fed provides regulation. As bankers gamed the system (that’s not a criticism, that is their job), some of these regulations changed and became stricter over time.
In 1978, the Humphrey-Hawkins Full Employment Act gave the U.S. government the goal of providing full employment. It also said that the Fed chairman must give testimony to Congress reporting on the state of the economy.
With the Fed mandated to enter the policy arena, it meant the Fed would no longer just have to worry about the longer-term problem of inflation, but a short-term problem, the current economy, as well. The Fed was given this responsibility because the same tools — money supply and interest rates — could be used in different ways to manage both inflation and economic issues.
Fast forward to the subprime mess, CDOs, Bear Stearns and Lehman Brothers — and boom! The Fed jumped in with both feet to make sure the financial sector and then the economic world did not completely spin off their axes.
And now the Fed is taking steps to remove one foot and then another, and returning to its past role as guardian of the money and inflation, and occasionally unemployment.
And that is the conundrum facing Wall Street right now: Is the Fed stepping back a good thing or a bad thing for stocks?
What’s This Mean for the Market?
First, stepping back means ceasing purchases of Treasury bills and ending other programs to inject liquidity into the market. The Fed is still buying boatloads of conforming mortgages, which are guaranteed by Fannie and Freddie (i.e., you and me), but they are starting to pull back.
Second, Uncle Sam, in the form of the FDIC, is also withdrawing guarantees of bank debt.
>
Third, the Fed is not making noise about extending the amount of money in the TALF program.
The bottom line: Credit support by the Fed and Uncle Sam is being pulled back.
Monetary purists — who read textbooks but do not live in the real world — think this is a great thing, as an excess amount of liquidity and lending due to the Fed must mean inflation.
But they are wrong — there is no excess. Most, if not all, of the money pumped into the system by the Fed is not being put into the economy. The banks are sitting on it, so there is actually no excess liquidity.
The Fed easing out of credit markets is a good thing in the long term for inflation and the U.S. dollar, which, in theory, is good for stocks. But, short term, this is bad for stocks.
Why?
Because a Fed pullback means less credit, which is not good for the economy, for companies or for corporate earnings.
The Fed’s Moral Crisis
The pullback in credit is necessary to insure we continue to have a free market economy and an independent central bank — a key component, perhaps the key component, historically, to prosperity and economic growth.
Wall Street thinks the Fed is having trouble making up its mind over what to do. Wrong. There is no identity crisis. The Fed is going to pull back credit and clean up its own balance sheet over time.
Rather, the Fed is suffering a moral crisis. As it pulls back, the economy will take a hit, meaning more unemployment, more political angst, more deferred educations and new business startups, and more hardships for citizens. While it may feel wrong, this is something the Fed must do.
And with the pullback in credit — and the hit our economy will take because of it — so goes the stock market. (See 10 Reasons the Market Could Crash in October. )
This rally we’ve been experiencing was made possible by the Fed’s actions to save the financial system.
And what the Fed giveth, it will certainly taketh away.
Let Michael Shulman help you make money on the short side of the stock market. Download a free copy of his new investing guide, Double Your Money — and Double it Again.
