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US Fed policy may be going Back to the Future

Economic growth, Financial Events, Futures trading
By Paul Hodges on 18-Aug-2011

bubbles.jpgToday’s 419 point fall on the Dow Jones Average, and $6/bbl fall in WTI crude oil prices, may not be just another example of the wild volatility that has come to seem normal in financial markets.

It may also mark the end of an era.

Since 1994, the US Federal Reserve has used all its resources to support the stock market in times of strain. This took it well beyond its official mandate of fighting inflation and supporting employment.

Instead, it meant interest rates were lowered, and liquidity provided, any time the market experienced a major sell-off. It created the dot-com bubble in 1999-2000; the subprime housing disaster; and more recently the bubble in energy and commodity markets.

Today, for the very first time in 15 years, 2 senior US Federal Reserve Governors have spoken out against this policy:

• Philadelphia Fed chief Charles Plosser said taking action after stocks tumbled “signalled that we are in the business of supporting the stock market.”
• Richard Fisher, the Dallas Fed chief, said the Fed “should never enact such asymmetric policies to protect stock market traders and investors.”

It remains to be seen whether this change of policy becomes permanent. There are very powerful forces, not only on Wall Street, ranged against it. Will the Fed really do nothing, if today’s falls continue next week?

But if it does, then financial markets will be quite different in 5 years time:

• Markets will not be protected from their own follies
• Investors who cannot evaluate credit risk will lose money
• Commodity prices will be driven by fundamentals of supply and demand
Computerised high frequency trading will disappear

Unfortunately, it is almost certain that the path back to reality will be extremely painful. 15 years of Fed ‘bubble-blowing’ will take a long time to put right. But if Plosser and Fisher really mean what they say, then Fed policy is indeed headed Back to the Future.