How can the federal reserve stimulate the economy?

Earlier this month in my article “The stock market is not the economy”, I discussed some of the structural and sector-driven reasons why the stock market was surging even though economic indicators are still in a very negative place.  I purposefully left out an extremely important consideration in that article:  The Federal Reserve and their role in “propping up” the stock market.  In simple terms, I’d like to just discuss some of the actions they’ve taken and mention some of the long-term consequences of those actions.

Over the past few months, the central bank has shown it will go to incredible lengths to stimulate the economy and stabilize the stock market. The result of those actions has allowed the stock market to retrace most of its post-coronavirus loss.  This move has been unprecedented in its scope and size, and there are some long-term consequences.  It’s hard to imagine a scenario where business closures, mass unemployment and a decline in global trade doesn’t have long-term effects for the economy, but that is the current situation we find ourselves in, for better or worse.  As I mentioned in my previous article, there has been a significant decoupling of the economic reality from the stock market.

Monetary relief efforts began in mid-March when the Fed announced plans to inject up to $5 trillion into failing money markets.  Later in March, the Fed cut its interest rates to close to zero for the first time since the 2008 financial crisis.

As most people are aware, these initial stimulus efforts were then followed by lending programs (including the Paycheck Protection Program) for small employers, households, and large businesses to help produce and maintain cash flow.

During the early days of the coronavirus crisis, when treasury markets were in turmoil, the Fed began buying notes (short-term government debt securities with maturity between one and ten years).  When small businesses started becoming insolvent, the central bank formed new credit operations.   But the largest influx of stimulus into the stock market was the bond buying program launched by the Fed, including treasury bonds, mortgage-backed securities, and shockingly even bond ETF’s. 

How does buying bonds and bond ETF’s stimulate the stock market?

The Fed's buyback program (“quantitative easing”) has purchased over 600 billion dollars in treasuries in some weeks, an amount that exceeds what the Fed would normally buy in nearly a year under previously buyback efforts.  They have even purchased large amounts of corporate bond ETF’s through a partnership with Black Rock Inc, a publicly traded investment company.  This is a line many finance experts didn’t think the Fed would cross, but the fed chair Jerome Powell has increasingly succumbed to political pressure to help stimulate the stock market, despite the poor shape of the economy.  Buying bond ETF’s provides liquidity to major holders of corporate debt, mostly banks.  This props up the price of the bonds (and lowers yields) and frees up cash for banks and other major financial institutions to purchase riskier assets, including stocks.  In simple terms, there is now more money available to purchase equity. This move is unprecedented because it represents over 10 years of liquidity pushed into the market in only a few months, and forces newly free money into riskier assets, which builds up the market through asset inflation instead of real economic growth.

What are the Consequences?

The stock market is not the economy, but in general the return of major stock indexes provides a forward looking peek into the estimated earnings of the companies that belong to those indexes.  Taken by itself, this should be a reasonable proxy for economic growth.  In other words, the stock market is not the economy, but they inform and interact with each other in a meaningful way.  The decoupling of this relationship is a major paradigm shift in not only how we estimate the intrinsic value of companies, but also in the relationship between economic and market theory.  Secondly, many ETF experts have argued that using bond ETF’s creates a false sense of liquidity because the ETF’s themselves are liquid, but the bonds they own aren’t.  The only way to rewind the actions of the Fed is to sell nearly a trillion dollars’ worth of corporate bonds that the ETF’s hold.  Obviously, this would crash the bond market, decrease liquidity, and erase many of the problems that the Fed “solved”.  The reality is that the U.S. government is now on track to become the largest lender of capital to corporate America, a level of government-market integration unprecedented in the “free market” of the United States.  They are “kicking the can down the road”, and pushing off the problem to another administration farther down the road.