1/18/2008

Fed Rx

The stock market is currently in turmoil.  The country hasn't seen sustained losses like this in many years.  The housing disaster, fickle oil prices, and the falling dollar have caused investor uncertainty, causing the market to suffer the consequences.  The market has fallen 2,000 points in a couple of months causing fear of a recession and a decrease in stock prices as demand for stocks falls.  In a recent article, by Michael Sivy from Money Magazine (found here), a new perspective is provided about the Fed's ability to influence and affect not only rates but the stock market in general.  He states that the markets do much better in times where the Fed cuts rates.  Market returns usually hover around 12% but rise to 17.4% during times of rate cuts.  As the Fed prepares to bail out the groaning economy by perhaps lowering rates again, equity investors can expect to see greater returns in the near future.  
It seems the lower rates obviously help businesses and decrease demand for debt instruments.  This shift in preference by the investing market leads to a more successful stock market for those willing to invest in such uncertain times.  While this change may be great for investors, it is truly sad that our economy must rely on intervention to save us from our own stupidity.  Bernanke, in yesterday's address to the budget committee, stated something to the effect that it is not the job of the Fed to protect investors from their own decisions. 

13 comments:

Dr. Tufte said...

-1 for a plurality agreement problem (waived).

It isn't a new idea that the Fed can influence (nominal) stock returns. It's less clear that they can influence real returns.

It probably doesn't follow that (all) businesses are helped by high rates of return. Obviously investors like this, but for businesses the high rates of return come about because returns are the same but the denominator used to determine rates - the stock price - is declining.

Lastly, I wouldn't worry about the Fed having to manage the economy. If you're against that, you probably should also be against doctors managing their patients health.

T.Pettinger said...

The problem is that in certain circumstances lower interest rates can cease to have any beneficial effect. One can this in the recent case of Japan.

Bitsy said...

I am a little concerned about the Fed micromanaging the economy. I think the economy is too complex to be controlled just by adjusting the funds rate. This CNN Money article http://money.cnn.com/2008/01/18/news/economy/cure.fortune/index.htm?postversion=2008012107 cautions the Fed against continuing to lower the interest rate because that eventually leads to runaway inflation. The author references sinilar conditions that led to inflation and recession in the late 1970's and early 1980's.

Dr. Tufte said...

Thanks to T. Pettinger for the well-taken outside comment.

This issue always needs to be in the back of our minds.

Dr. Tufte said...

Just an opinion for Bitsy.

I don't think it is reasonable to think that the Fed "micromanages" the economy.

I do think it certainly seems this way from the way the media talks about the Fed. But, the reality is that they are about as hands-off as they dare to be.

Trinity said...

I posted this comment before the Fed cuts rates yet again. This recent .75 rate cut adds even more fuel to my fire. It is far too much intervention. It is the Fed's job to manage (as Dr. Tufte reminded me) but not control the economy. This recent bailout is too much. It might be scary for the to just stand aside and watch what happens but it might be the right step in letting the markets readjust after all the stupid things people have done in the credit and housing markets. Perhaps we should let the banks reap what they have sown.

Trinity said...

Sorry to bring up another bit on the interest rate cuts but I just came across an article about negative effects of the cut. Low rates chase away foreign investors which further weaken the dollar especially as threats of inflation and slowing growth materialize.
The article can be found here:
http://money.cnn.com/2008/01/24/news/economy/barr_interest.fortune/index.htm?postversion=2008012511

Dr. Tufte said...

Aargh - it lost my comment!

I agree (broadly) with both points.

I think the legacy media is feeding people a lot of crap here. This isn't about "bailing out banks". The Fed doesn't work that way. Saying it does doesn't make it so. And, there is a risk of more inflation. But, the Fed raises and lowers rates all the time. If you don't hear this line all the time, you should be suspicious of why they are saying it this time.

Gavin said...

Extra Credit - Dr. Tufte
If the Fed is the economy's doctor, I think they should recommend a more responsible economic cycle rather than prescribe medication(rate cuts) and emergency surgery(economic stimulus packages).

TheFindlay said...

Dr. Tufte
Shouldn’t patients manage their own health and let doctors make repairs when necessary. This is my take on a businesses relation in terms of the Fed. I think there is enough of a significant difference to back this up by what Bernanke was quoted as saying in the original post. Corporations must keep themselves healthy; this is not the job of the Fed. The Fed’s job is to keep the economy running smoothly; well, at least this is their ideal.

TheFindlay said...

Dr. Tufte
I agree with you on the point that the Fed does not micromanage the economy. They manhandle the economy when they have to and they act as if they don’t exist when the economy lets them. I think we should always listen to what the Fed has to say and act when they act. Action is what scares me when it comes to the Fed.

TheFindlay said...

Dr. Tufte
Relying to your comment after some time has passed may make you want to revise your comment. Bear Stearns was bailed out by the Fed no question about it. I don’t think I have ever before heard of “The Legacy Media” and I wonder what exactly that refers to. The Fed does change interest rates all of the time but usually not in a panicked frenzy as they seem to be doing recently.

Dr. Tufte said...

-1 on thefindlay for a spelling error.

It's May now, and Trinity's point has come back to haunt us: the run-up in commodity prices this spring is because people can't get the returns they need out of financial investments because the Fed has driven rates down.

The legacy media is the networks and the newspapers that are failing because they can't provide a product that people want: the analogy is to legacy software.