The Fed's Manipulation of the Stock Market

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

The New York Investing meetup has made a companion video to this blog entry. To see it, please go to: http://www.youtube.com/watch?v=Sobq7wCXjUw.

The Federal Reserve began a campaign of blatant and purposeful manipulation of the U.S. stock market on August 15, 2007. One hour before the futures expired for the month, it announced a surprise cut in the discount rate. Dow futures rose almost 300 points immediately (there was some noticeable rise just before the close the previous day, indicating some big money players had probably been tipped off early) and the huge profits of the shorts evaporated in an instant just before they were about to be cashed in. This changing of the rules just before the game was over had no justification as per the Fed's official mission. Lowering the discount rate one hour later would have had no difference in impact on employment or inflation . It did make a difference on the bottom line of the issuers of the futures (some of whom may have board seats on the regional Federal Reserves), who received a sudden windfall because of the Fed's destruction of this free-market trading mechanism.

As unconscionable as the Fed's actions were on August 15th, they were only beginning of a long campaign aimed at propping up the U.S. stock market. The Fed's rate cutting began in earnest on September 18, 2007 with a 50 basis point cut in the Fed Funds rate. The market already having rallied since the surprise August move by the Fed reacted with great enthusiasm continuing to go up and hitting new highs by early October. However like a junky who continually needs a larger dose of drugs to maintain a high, the U.S. stock market needed larger doses of Fed stimulation to stay at a high as well.

When there was only a 25 basis point cut it late October, stocks started selling off. The Fed realizing things weren't going as planned, did its largest liquidity injection into the U.S. financial system since 9/11 the very next day. This still wasn't enough stimulation for the market however and stocks continued to sell down. In mid-November, the Fed announced a substantial end of the year liquidity boost that finally arrested the selling -at least for a short while. The December rate cut of 25 basis points was also not enough for the market and stocks sold off the following few days. Even the new TAF (term auction facility) announced at the time was only good for a very short rally.

By the beginning of January, the stock market was clearly falling apart. On the third trading day of the year, stocks gapped down and heavy selling was taking place. The Fed then announced an increase in the amount of the TAF. This had little noticeable impact on the selling. On Martin Luther King day, U.S. markets were closed, but markets in Europe and Asia were going into free fall. Before the U.S. markets opened the next morning, the Fed announced the first interim meeting rate cut since 9/11. The huge 75 basis point cut was the biggest since the early 1980s. It worked in stabilizing the U.S. stock markets, but was not enough to make them go up. Only eight days later this was followed a 50 basis point cut and the markets still seemed to languish.

By early March stocks hit even lower lows and the market looked like it was about to fall apart just as the Bear Stearns crisis hit. The Fed would respond with an injection of liquidity that was so massive that what came before seemed almost insignificant in comparison. With international markets once again leading the way down, the Fed moved to bailout Bear Stearns, guaranteeing $30 billion of its questionable loans. The TAF auctions were up to two $50 billion auctions for the month. Two new credit facilities were created the TSLF (Term Securities Lending Facility) and the PDCF (Primary Dealer Credit Facility) with the purpose of moving hundreds of billions of dollars more into the financial system. The regular credit operations of the Fed were upped to the max as well. And to top it all off another 75 basis point cut in the Funds rate was added for good measure.

Why did the Fed embark on the path that it did, seemingly oblivious to the destruction it was wrecking on the U.S. dollar and the potential risks of out of control inflation? The simple answer was the Fed was desperate to prevent a recession in an election year and became myopic to all other implications of its actions. As the New York Investing meetup had predicted previously, March would be the end of most of the Fed's rate cutting if this was indeed the case. Since it takes about six months for Fed cuts to effect the economy and the election was in early November, the biggest impact of a fed action would result if it took place by March. This is not to say the Fed would do nothing in the months that followed, only that it moves then would have much less impact on the election.

Ben Bernanke was not just myopic concerning a possible recession however. He was also myopic concerning inflation. According to his research the Depression could have been prevented if the Fed had increased liquidity dramatically in the beginning and acted to prevent bank failures - exactly the actions he has been engaging in. However, the U.S and world were very different places in the 1930s than in the early 2000s. Currencies didn't float, the dollar wasn't in a severely weakened state, the U.S. wasn't the biggest creditor nation in the history of the world; the U.S. economy wasn't based overwhelmingly on consumer spending and borrowing, but on manufacturing and agriculture; and globalization hadn't shifted economic power to other countries. To apply ideas that might have worked in the 1930s to the situation that existed in the 2000s was pure folly. It wouldn't be the first case of governmental folly in the history of economics. Indeed, widespread mishandling by those in charge is a necessary condition to create a major economic disaster.

NEXT: Credits of Mass Destruction

Daryl Montgomery

Organizer, New York Investing meetup

For more about us, please go to our web site: http://investing.meetup.com/21