Federal Reserve: A Bit Player

When talking to any number of clear headed and knowledgeable market analysts, it often shocks me at the confidence and certainty with which the Federal Reserve Bank is credited with the rebound of financials markets from 2009 to 2016.  It appears as though this assessment is guided by faith alone and yet there are numbers that seem to support the claim.  This article cannot dispel the religious reverence for the Federal Reserve’s apparent powers.  However, it is hoped that we can demonstrate that the Federal Reserve may be a bit player on a grand stage of market forces.

The Claim and Its Origins

Since the financial “crisis” of 2007-2009, many astute observers have pointed out the exceptional amount of data showing the unprecedented increase in the Federal Reserve’s balance sheet.  So dramatic is the change since 2009 that there seems to be no fair comparison.  Below is the Total Reserves Maintained with Federal Reserve Banks [RESBALNS] in billion of dollars:

Without any form of filtration, all prior periods of increase or decrease in RESBALNS appear as a flat line in comparison to the period from 2009 to the present.  The lone relative comparison is the Percent Change From Year Ago applied to the same data charted above.

Again, the period from 2009 renders all other periods obscure in comparison.  So, on the surface, any person looking at the Federal Reserve data can confidently claim that the cause of the stock market rise from 2009 to the present is because of the expansion of the Federal Reserve balance sheet through the use of unique policy tools and techniques.  But is this time really any different from the past?

Our contention has always been that any significant decline in the stock market will result in an equal and opposite reaction regardless of Federal Reserve involvement.  We’ve already demonstrated the performance of the stock market when a Federal Reserve didn’t exist. The purpose of that examination was to prove the opposite of the claim that the Federal Reserve is the sole or primary cause of a stock market rise.  In that article, we demonstrated, in the period from 1837 to 1914, that the stock market would increase in a similar magnitude to the 2009-2016 period regardless of whether there existed a governing central bank.

This piece will focus on the period since the existence of the Federal Reserve from 1918 until the present. One central argument is that the sheer magnitude of involvement by the Federal Reserve is the primary reason for all financial markets to rise from the lows in early 2009.  We don’t deny that the Federal Reserve is highly active in trying to change the outcome of the markets.  However, our claim is that Federal Reserve activity simply doesn’t matter as markets will move inexorably towards levels of undervaluation and overvaluation.

Turning Back the Dial

For the sake of illustration, we are going to use the St. Louis Adjusted Monetary Base [AMBNS]* data to demonstrate our claim. However, in order to make the claim we’re going to show the same representative examples for this new set of data.  We will show the absolute numbers and the longest range of history we can find and we will show the Percent Change From Year Ago as well to confirm that there is a reasonable relationship.

In the chart below, we’re using the St. Louis Adjusted Monetary Base [AMBNS] in billions of dollars from 1918 to the present. 

Again, the St. Louis Adjusted Monetary Base shows the dramatic change that occurred in the period from 2010 to the present, relative to the prior range. Additionally, we’re including the Percent Change From Year Ago for the AMBNS to show the representative change that has taken place, almost since the inception of the Federal Reserve Bank.

Again, the period of 2009/2010 clearly stands out as an exceptional time, although not as significantly as the similar RESBALNS percentage change chart.  Our look at the change in the St. Louis Adjusted Monetary Base is important because it demonstrate the general relationship between the more often cited data set showing RESBALNS.  In order to broaden our own claim on a time scale, we prefer the greater timeframe offered by AMBNS which reflects similar but not the same information.

We believe that the above look at two sets of data have sufficiently give enough of a starting point for the remaining context needed to see that while the Federal Reserve has been active since 2009, it hasn’t translated into the perceived gains in either the stock market or economy.  In this article, we’ll start with the impact on the stock market, easily the best reference point since stock market data is set once recorded, unlike government economic data.

By “stock market” we mean the Dow Jones Industrial Average since it contains the data that is subject to the most continuous real-time pricing.  While there is a contingent of market analysts who prefer the S&P 500 for market data, that index did not exist prior to 1957 and all other data prior to 1957 is taken on faith to be accurate rather than on fact.

Now comes the challenge to those who claim that this time is different. Does any of the data from the past reflect, even remotely, the same outcome that they’re currently proposing?  If they can’t find the same level of coincidence, why is now any different than in the past? 

Is This Time Different?

The primary contentions by those who are worried about the Federal Reserve’s “bandage over a hemorrhage” policy is that it is unprecedented and that this policy is the reason why all financial markets have attained such phenomenal heights after the global debt and housing collapse from 2006 to 2009. 

When considering this issue, we have to ask ourselves, what are the odds that not only a full recovery is experienced in the stock market, though unwarranted, but also a meager recovery in select housing markets and a underwhelming rebound in employment?  From prior markets since the inception of the Federal Reserve, it would appear that the odds are significantly in favor of a full rebound.  In addition, not only is the current stock market rise expected, it is only average in comparison to previous market rebounds that have followed a stock market decline of –35% or more.

When we exclude the market rise from 1942-1966 & 1982-2000 (secular bull markets), the average increase in the stock market after an average decline of –43% was +238%.  When we include all of the above market declines and subsequent market increases, the stock market averaged an unrealistic increased of +450% based on an average preceding decline of –39%.  We don’t buy the idea that the market would increased +450%, however, the +239% increase of the stock market fits in with our examination of the period from 1837-1914, when a Federal Reserve Bank didn’t exist.

Conclusion

Yes, the Federal Reserve is very busy trying to impact the outcome of the financial markets.  However, none of the available data going back in time long enough to be meaningful can confirm a correlation between the increased in monetary base or reserve bank balances and the subsequent rise in the stock market. Additionally, the same lack of correlation can be found in shadow banking, M1, M2, 10-year yields or any of the many suggested correlations made to support the claim that Federal Reserve policies (such as QE∞, ZIRP, TALC, TALF, etc.) or other actions altered the outcome of the markets financial. 

What we’re witness to in complaints about the Federal Reserve and their policies is primarily based on a recency bias that allows commentators to let their claims go unchecked and proliferate.  The fringe of the recency bias crowd seizes on the fear element, and the willingness of a majority of investors who are currently fighting yesterday’s war on a “bubble”, to propagate untested and unsupported claims.

Exhibit 1: 1918-1929

Since the data for the St. Louis Adjusted Monetary Base starts in 1918, we’ll start by comparing the stock market performance from 1918 to 1929.

Looking at the St. Louis Adjusted Monetary Base data we see the following from 1918 to 1933:

In the period from the low in the stock market from 1921 to the peak in 1929, the stock market increased by +497% after experiencing a prior decline, from the 1919 peak, of –46.58%.  At the same time, the adjusted monetary base increased by +12.45%.  In this example, we can eliminate the Federal Reserve’s action as the sole reason for the rise in the stock market.  There were many factors, however, if we based the contributing factor on the change in the monetary base with stock market increased then we couldn’t ascribe the exceptional gains to such a minor increase.

Exhibit 2: 1932-1942

Next we have the Dow Jones Industrial Average for the period of 1932 to 1942.

And the St. Louis Adjusted Monetary Based from 1932 to 1942.

In the change that occurred in the stock market, we saw an increase of +371.62%.  Again, this increased was preceded by a stock market decline of –89% from 1929 to 1932.  At the same time, the St. Louis Adjusted Monetary Based increased by +231.18%.  The relative change between the stock market and the monetary based from Exhibit 1 and Exhibit 2 seems to suggest that the increase in the monetary based had some effect.  However, we can’t pinpoint why the rise in the stock market was so much less even though the change in the monetary base was so much higher than in Exhibit 1.

Exhibit 3: 1942 to 1966

Below is the performance of the Dow Jones Industrial Average from 1942 to 1966.

Below is the change in the monetary base from 1942 to 1966.

The Dow Jones Industrial Average increased +970% in the period from 1942 to 1966 while the St. Louis Adjusted Monetary Base increased by +198% in the same amount of time.  Again, the effect of the changed in the monetary base does not seem to evenly translate into the gains in the stock market.  The rise in the Dow Jones Industrial Average was preceded by a decline of –52% from 1937 to 1942.

Shedding new light on the topic is change in the Total Reserves Maintained with Federal Reserve Banks [RESBALNS] from the period of 1950 to 1966.  From January 1950 to February 1966, the RESBALNS increased +11.79% as contrasted with the St. Louis Adjusted Monetary Based increase of +54.77% over the same period of time.

Exhibit 4: 1970 to 1973 & 1974 to 1976

In the following display, we show the Dow Jones Industrial Average through the period from 1966 to 1982.

Below is the expansion for the St. Louis Monetary Base for both periods 1970-1973 and 1974 and 1976.

On two occasions the stock market declined by –36% (1966-1970) and –45% (1973-1974) followed by rebounds of +66% and +75%, respectively.  Meanwhile, the St. Louis Monetary Base [AMBNS] increased +24.78% from 1970 to 1973 and +8.42% from 1974 to 1976.  In addition, the Total Reserves Maintained with Federal Reserve Banks [RESBALNS] increased +14% from 1970 to 1973 and fell –13% from 1974 to 1976.

Exhibit 5: 1982 to 2000

Below is the stock market performance from 1982 to 2000.

Below is the change in the Total Reserve Balances Maintained with Federal Reserve Banks AND St. Louis Adjusted Monetary Base from 1982 to 2000.

As far is the stock market, it gained +1,402% over the 1982 to 2000 period.  However, the two measure of monetary base and total reserves when in opposite directions with the St. Louis Adjusted Monetary Base increasing +319% while the Total Reserve Balances with Federal Reserve Banks declined –80%.

Exhibit 6: 2002 to 2016

Below is the performance of the Dow Jones Industrial Average from 2002 to the present.

Below is the St. Louis Adjusted Monetary Base [AMBNS] covering the periods 2002 to 2007 and 2009 to 2016.

In two prior instances, the stock market declined –37% in the period from 1999 to 2002 and –53% from 2007 to 2009.  In the subsequent rise of the stock market, the Dow Jones Industrial Average increased +94% from 2002 to 2007 and +184% from 2009 to 2016.  Additionally, the monetary base increased +20% from 2002 to 2007 and +131% from 2009 to 2016. Finally, in the same corresponding periods, the Total Reserves with Federal Reserve Banks shows the same 2002-2007 & 2009-2016 periods.

 

*Why choose the Adjusted Monetary Base?

The current claim that the financial markets couldn’t have possibly achieved the current rebound without the help of  Federal Reserve stimulus and jawboning  is the modern version of the old “expanding monetary base” argument of the past. 

"Thus, any attempt by the Fed to greatly expand the monetary base would simply drive interest rates up as well. Booming the monetary base would simply push interest rates to new highs, thereby frustrating the intentions of the Fed...(Richard Russell. Dow Theory Letters.  June 16, 1982. page 5.)."

"This kind of parabolic rise always ends with a bust. What bothers me is that I think we’re approaching a situation wherein the Fed will hesitate to provide enough upside acceleration in the monetary base to keep industrial production rising (Richard Russell. Dow Theory Letters.  February 9, 1983. page 2.)."

Then as now, the point was made that rapid increase of the monetary base would cause a bubble and bust.  What goes unmentioned is that a market boom and bust is inevitable if we have a normal functioning economy.  The only distinction is the magnitude of the boom and bust which no central banking authority can control.