Just a quick note on this Christmas Eve. The US stock markets are falling. The bull market that had started in March 2009, two months after Obama took office, and which then continued through to the end of Obama’s two terms, may be close to an end. A bear market is commonly defined as one where the S&P500 index (a broad stock market index that most professionals use) has fallen by 20% or more from its previous peak. As of the close of the markets this December 24, the S&P500 index is 19.8% below the peak it had reached on September 20. The NASDAQ index is already in bear market territory, as it is 23.6% lower than its previous peak. And the Dow Jones Industrial average is also close, at a fall of 18.8% from its previous peak.
Trump is blaming the Fed for this. The Fed has indeed been raising interest rates, since 2015. The Fed had kept interest rates at close to zero since the financial collapse in 2008 at the end of the Bush administration in order to spur a recovery. And it had to keep interest rates low for an especially long time as fiscal policy turned from expansionary, in 2009/10, to contractionary, as the Republican Congress elected in 2010 forced through cuts in government spending even though employment had not yet then fully recovered.
Employment did eventually recover, so the Fed could start to bring interest rates back to more normal levels. This began in late 2015 with an increase in the Fed’s target for the federal funds rate from the previous range of 0% to 0.25%, to a target range of 0.25% to 0.50%. The federal funds rate is the rate at which banks borrow or lend federal funds (funds on deposit at the Fed) to each other, so that the banks can meet their deposit reserve requirements. And the funds are borrowed and lent for literally just one night (even though the rates are quoted on an annualized basis). The Fed manages this by buying and selling US Treasury bills on the open market (thus loosening or tightening liquidity), to keep the federal funds rate within the targeted range.
Since the 2015 increase, the Fed has steadily raised its target for the federal funds rate to the current range of 2.25% to 2.50%. It raised the target range once in 2016, three times in 2017, and four times in 2018, always in increments of 0.25% points. The market has never been surprised. With unemployment having fallen to 5.0% in late 2015, and to just 3.7% now, this is exactly one would expect the Fed to do.
The path is shown in blue in the chart at the top of this post. The path is for the top end of the target range for the rate, which is the figure most analysts focus on. And the bottom end will always be 0.25% points below it. The chart then shows in red the path for the S&P500 index. For ease of comparison to the path for the federal funds rate, I have rescaled the S&P500 index to 1.0 for March 16, 2017 (the day the Fed raised the target federal funds rate to a ceiling of 1.0%), and then rescaled around that March 16, 2017, value to roughly follow the path of the federal funds rate. (The underlying data were all drawn from FRED, the economic database maintained by the Federal Reserve Bank of St. Louis. The data points are daily, for each day the markets were open, and the S&P 500 is as of the daily market close.)
Those paths were roughly similar up to September 2018, and only then did they diverge. That is, the Fed has been raising interest rates for several years now, and the stock market was also steadily rising. Increases in the federal funds rate by the Fed in those years did not cause the stock market to fall. It is disingenuous to claim that it has now.
Why is the stock market now falling then? While only fools claim to know with certainty what the stock market will do, or why it has moved as it has, Trump’s claim that it is all the Fed’s fault has no basis. The Fed has been raising interest rates since 2015. Rather, Trump should be looking at his own administration, capped over the last few days with the stunning incompetence of his Treasury Secretary, Steven Mnuchin. With a perceived need to “do something” (probably at Trump’s instigation), Mnuchin made a big show of calling on Sunday the heads of the six largest US banks asking if they were fine (they were, at least until they got such calls, and might then have been left wondering whether the Treasury Secretary knew something that they didn’t), and then organizing a meeting of the “Plunge Protection Team” on Monday, Christmas Eve. This all created the sense of an administration in panic.
This comes on top of the reports over the weekend that Trump wants to fire the Chairman of the Fed, Jerome Powell. Trump had appointed Powell just last year. Nor would it be legal to fire him (and no president ever has), although some may dispute that. Finally, and adding to the sense of chaos, a major part of the federal government is on shutdown starting from last Friday night, as Trump refused to approve a budget extension unless he could also get funding to build a border wall. As of today, it does not appear this will end until some time after January 1.
But it is not just these recent events which may have affected the markets. After all, the S&P500 index peaked on September 20. Rather, one must look at the overall mismanagement of economic policy under Trump, perhaps most importantly with the massive tax cut to corporations and the wealthy of last December. While a corporate tax cut will lead to higher after-tax corporate profits, all else being equal, all else will not be equal. The cuts have also contributed to a large and growing fiscal deficit, to a size that is unprecedented (even as a share of GDP) during a time of full employment (other than during World War II). A federal deficit which is already high when times are good will be massive when the next downturn comes. This will then constrain our ability to address that downturn.
Plus there are other issues, such as the trade wars that Trump appears to take personal pride in, and the reversal of the regulatory reforms put in place after the 2008 economic and financial collapse in order not to repeat the mistakes that led to that crisis.
What will happen to the stock market now? I really do not know. Perhaps it will recover from these levels. But with the mismanagement of economic policy seen in this administration, and a president who acts on whim and is unwilling to listen, it would not be a surprise to see a further fall. Just don’t try to shift the blame to the Fed.