Critics of the Federal Reserve are popping up everywhere. They say that the Federal Reserve is not paying attention to “what markets are telling” about the economy. Critics have forgotten what impact zero interest rates had and are still having. If investors can’t earn anything in bonds, they put their money into stocks and real estate, bidding up those prices. When interest rates start to normalize (e.g. rise), bonds become more attractive, and money flows into bonds rather than stocks.
Another perspective – shares of stock in a company reflect the earnings the company makes and is expected to make. The price of the share multiplied by the number of shares outstanding is the value of the company. Similarly, the value of our stock markets must collectively reflect the value of USA Inc., the value of the production of all of our companies taken together.
Share prices have not been connected to reality for some time, thanks to the Federal Reserve artificially holding rates down for so many years. This created distortions that will still take years to resolve. Since 2008, the S&P 500 stock index has risen 110 percent. But our output, measured by GDP, has increased only 25 percent over the same period. This indicates that the growth in output owned by each share has lagged far behind the share price, or, viewed another way, there is less real output per dollar of share price, a lower real return. So, as interest rates rise, bonds provide an attractive alternative to owning stocks and stock prices will weaken as investment money shifts to Tbonds.
The zero interest policy pursued by the Federal Reserve was not good policy, distorting one of the most important prices in the economy, the cost of capital. When bonds pay so little, then even ventures promising a low return look attractive to capital investors. QE drove up asset prices (instead of goods and services prices – inflation), distorted the distribution of wealth (in favor of the wealthy), and failed to trigger a hoped-for increase in spending due to higher nominal (not real) wealth. It is important to return the setting of interest rates to markets, not to policy management. This is hard to do. The Fed bought $4 trillion of financial assets from the private sector and gave it cash, liquidity, in exchange. That liquidity went looking for a comparable return and couldn’t find it. Now the Fed is returning those assets to the private sector, letting bonds mature and giving the proceeds back to the Treasury. This is a de facto reduction in bond demand, lowering bond prices and raising bond yields (e.g. interest rates).
So, yes interest rates should rise and no, the Fed should not abandon its policy simply because the stock market is declining. Normalizing interest rates means normalizing asset prices. Much of the “real” economy is at record high levels for this expansion. It is hard to get even more real growth from this level (full employment) going forward. The Fed does want to get as far away from “0” interest rates as it can in anticipation of needed cuts in the future. But it will not do this by risking a recession. At full employment, the best you can do without inflation is to keep the economy steady at its current high level of employment, there isn’t much room for growth beyond 2 percent (population growth + productivity gain). Monitoring the incoming data is the best strategy the Fed has to hold the economy steady at current lofty levels.