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Why Stock Market Upheaval Was Inevitable

James A. Dorn

The sharp plunge in stock markets around the world
earlier this week tells us that major central banks, with the US
Federal Reserve at the forefront, have severely underestimated the
risk of keeping interest rates too low for too long. Now that
markets expect higher rates — due to improved economic
growth, higher inflation, growing fiscal deficits, and the
unwinding of central bank balance sheets — it has become
clear that monetary stimulus created a pseudo wealth effect, and
that suppressing interest rates by unconventional policy to spur
risk-taking and pump up asset prices was itself a risky
strategy.

The long stock market rally
since 2009
was fueled in large part by the Federal Reserve’s
unconventional monetary policies. By promising to keep its policy
rate (the federal funds rate) near zero “for a considerable period
of time” and engaging in large-scale asset purchases, known as
“quantitative easing,” the Fed hoped to boost asset prices and
stimulate the economy.

A law of the market is that when interest rates fall, asset
prices rise. As long as markets believe the Fed will support asset
prices by keeping rates low, stocks will be the investment of
choice, rather than conservative, low-yield saving accounts, money
market funds, or highly-rated bonds.

But now it seems markets don’t believe those helpful Fed
policies will last much longer. The uptick in economic growth
forecasts, the expectation of higher inflation, and the growing federal
deficits are putting pressure on the Fed to increase the pace of
their policy rate hikes. Markets are now factoring in those forces
and the realization that stock prices are not on a sustainable path
— hence a big sell-off.

Such a downturn was inevitable, because reality tells us that
there has been a mismatch between the economy and the stock market.
Fed policy did not — and could not — permanently
increase real economic growth and wealth. If it could, then the
best policy would be to simply run the money printing presses day
and night. When stock prices increase by double digit percentages
for more than seven years while economic growth is sluggish (last
year the Dow increased by 25% and the economy grew by
less than 3%), something is amiss.

And we’ve seen what happened to the market in previous instances
when it seemed like the Fed was going to change course. In 2013,
when Fed Chairman Ben Bernanke indicated he might start exiting QE
— decreasing the support for stocks — markets dropped
sharply in the famous “taper tantrum.” Bernanke quickly reassured
markets that the low-rate policy and QE would continue, and markets
resumed their upward trend.

The fear now is that the new Fed chairman, Jerome Powell, may
have to quicken the pace of interest rate hikes and speed up the
unwinding of the Fed’s huge portfolio of mortgage-backed securities
and longer-term Treasuries, or else the Fed will lose control of
its ability to manage inflation. Given the inverse relationship
between interest rates and asset prices, investors rightfully are
looking to reduce the weight of stocks in their portfolio before
rising rates cut into the gains made over much of the last
decade.

And there are other factors that may push up interest rates, and
push equity prices down in the process. There is the expectation
that with President Trump’s
$1.5 trillion tax cut
and plans for increased spending,
fiscal deficits will grow, leading to higher
interest rates as the government enters the bond market to cover
its deficit spending. Floating more bonds will decrease their
prices and increase their yields, attracting more investors into
bonds and out of stocks.

The only sure path toward future prosperity is to let free
markets determine interest rates and the allocation of credit.
Private saving finances productive investment that increases future
real income and consumption. That linkage is an iron law of
economics.

When government tries to circumvent that law, it may create
short-run stimulus, but in the long run the ill effects become
apparent. Financial booms generated by loose monetary policy can
last for a considerable time, but central banks never know when to
take the punch bowl away. And when they do, the boom is followed by
a bust.

As interest rates return to normal and the Fed exits its
unconventional policy, there will be some financial turmoil.
However, if policymakers put monetary, fiscal, trade and regulatory
policies on a sound path, the economy will prosper — and so
will asset markets.

James A. Dorn is vice president for monetary studies and a senior fellow at the Cato Institute in Washington, DC.