The Fed Isn’t Moving the Stock Market, or the Price of Credit

In a meeting with pollster Brett Lloyd last week, he indicated that a number of U.S. Senate seats increasingly lean Democratic. After which, House seats are far more in play than is normally the case in midterm elections where the White House occupant is rather unpopular. It’s something to think about, particularly with the stock market top of mind.

Conventional wisdom from the past week has been that “hawkish” comments from Fed Chairman Powell in Jackson Hole have been the driver of the stock market’s much-commented on retreat. Readers would be wise to dismiss the wisdom as it’s rooted in a misunderstanding of how markets work.

Surprise is the source of big market moves. This rates real thought as applied to Powell’s comments simply because there was nothing surprising about them. It’s long been known that the conventional thinker in Powell believes the answer to what economists deem “inflation” is more intervention from the entity (the Fed) that is empowered to keep “inflation” in check. Powell is conventional, which means he’s predictable. He said nothing new in Jackson Hole.

Which means we should look elsewhere for the sudden shift in the markets. The guess here is that it’s political. For the longest time it was a known quantity that the Republicans would enjoy big gains in the House come November, and likely take the Senate.

About what’s been written about predicted Republican gains, it’s not a bouquet being thrown the way of the GOP as much as it’s a comment about what markets seem to like: history says they like inactivity in Washington. With good reason. All legislation, whether good or bad, can have destabilizing qualities that investors must price. Conversely, gridlock removes what happens in Washington as a market threat. The long-predicted Republican gains would exist as a check on government intervention.

Except that the presumed electoral restraint on government isn’t as sure of a thing as it once was. See Brett Lloyd above. If so, imagine a nothing-to-lose president in Biden working with Democratic majorities, or a Democratic senate in concert with a Republican-controlled house won with the slimmest of margins. It presumably changes the legislative landscape for it putting interventionist legislation in play. Markets are information personified, and they relentlessly price possibilities. The surprise isn’t the Fed, but it would be a big surprise if an unpopular president actually gains a mid-term mandate.

Bringing it back to the Fed, it remains the case that what it does just isn’t that important. Consider a recent opinion piece by the very excellent Judy Shelton. She’s a Fed critic with good reason, and the central bank is less of a place without her. What’s a monument to GroupThink could have profited from Shelton’s contrarian ways.

At the same time, Shelton came off as less contrarian in her latest. She contends that “The Fed could crush demand by raising interest rates to stratospheric levels,” but Shelton knows that’s reducing to absurd what is an impossibility. Not only is this most conventional of central banks not going to raise rates to “stratospheric levels,” it also couldn’t. The Fed can’t decree credit expensive any more than the Mayor of New York City can decree apartments cheap. Markets always and everywhere have their say, and this is most crucially the case with credit. Figure that it’s produced around the world, at which point production is a magnet for the money that moves the production to its highest use. Market actors would rapidly and easily work around stratospheric rates which, by their very description, would signal an artificiality that markets are expert at correcting.

From there, Shelton writes that the Fed’s inflation fighting (supposedly higher central bank rates dampen inflation) could be erased “through fiscal measures that expand spending power – cash payments, subsidies, rebates, student loan forgiveness.” Except that Shelton knows this isn’t true. She has long caucused with the supply-side crowd, which means she knows well that government can in no way increase demand. It can’t because government isn’t some “other” as much as its spending power (including its ability to forgive debt) is a consequence of it having claims on the present and future production of the American people. In other words, government’s ability to dole out spending power springs from the productive seeing their spending power reduced. There’s no increase in demand to speak of. While government spending is a horrid tax, and arguably the most economically crushing of taxes, it’s not inflationary.

There’s no disagreeing with Shelton that the goal should be to reduce the burden of government, and that “greater output should be the goal.” For certain. If we shrink government allocation of precious resources, we’ll get more production, or more “supply.” To be clear about the supply, it won’t be “deflationary” any more than a lack of supply is inflationary. Supply and demand balance, as Shelton well knows, which is why it didn’t ring true her assertion that the inflation of the moment is “largely driven by a lack of supply.” Reduced supply is the same as reduced demand.

It all raises a basic question: why is Shelton being so restrained in her commentary? She knows what inflation is: it’s a decline in the unit of measure used to facilitate exchange. Translated for those who need it, inflation is currency devaluation. Which means the answer to inflation isn’t more supply, it’s not less government spending, it’s just a stable dollar. Except that the dollar’s exchange rate has never been part of the Fed’s policy portfolio. Shelton knows this too.

The Fed just isn’t that important. Not from a stock market perspective, and not from an inflation perspective. Eventually this contrarian view will become mainstream.