Fed Fund Fallacies: The Myth of the Almighty Fed

by: Abnormal Returns

A consensus has been built up around around the case for the Fed pausing its campaign of Fed fund rate hikes at their meeting today. This raises two questions? First, is this the right decision? Second, does it really matter?

First a quick note on the budding consensus. Prior to the employment report on Friday, the markets were putting a roughly 60% probability for a pause at 5.25%. After the report that percentage rose to 85%. Eduardo Porter of the New York Times lays out the challenge facing Fed forecasters at this point in time. As Michael Hudson, of the Wall Street Journal, writes that the markets are in a sense giving the Fed the “green light” to pause. John M. Berry at Bloomberg.com writes what is generally believed to be the consensus case surrounding Fed policy - in short a pause. Caroline Baum at Bloomberg.com lays out the contingency plan for the Fed in case inflation continues rising subsequent to the anticipated pause.

Barry Ritholtz at the Big Picture examines the trade-off facing the Fed. The question he raises is whether the risk of a “pause & resume” scenario is more damaging than the risk of the Fed overshooting in the first place. The bottom line for investors is that the economy is slowing, the only question is how much and with how much inflation? Daniel Gross looks to downside and points to a Martin Feldstein op-ed that argues that a soft landing with slowing inflation is increasingly unlikely.

In regards to the question of the relevance of the Fed, we are of two minds on the subject. Clearly in the short run the Fed can have a material impact on the capital markets. The big existential question is whether the long run is simply the accumulation of a series of short term events, like Fed actions, or whether it is in the end independent of these short term perturbations?

Eddy Elfenbein of Crossing Wall Street trots out some interesting statistics on the impact of Fed policy on the equities market. The bottom line is that when interest rates are falling, annual equity returns are some 6% higher than when interest rates are rising.

It is worth pointing again to a piece by John Hussman at Hussman Funds who has a pretty stark view on the subject. To Hussman, “The Fed is irrelevant.” The real issues surrounding the American economy are largely outside the purview (or influence of) the Federal Reserve. Hussman believes the vast majority of investors spend too much time focusing on the minutiae of largely transient events.

Although we earlier expressed the opinion that increasing economic uncertainty could lead to higher equity market volatility, maybe it just doesn’t matter as much any more. Alistair MacDonald of the Wall Street Journal examines the de-coupling of large multi-national corporate earnings and the domestic economy.

“Years ago, people would have made a connection between developments in [national] economic activity and what it meant for the [that country’s] stock market,” says Darren Winder, a strategist at UBS in London. “Now people realize it has more to do with developments in global economics.”

If true this has implications for portfolio diversification as well. The bottom line is that we live in an increasingly dynamic global economy where historical relationships fade and new ones form. Clearly the Fed can have an important impact on the capital markets in the short term. While the question of the long term is a bit more theoretical (and philosophical), we would do well to keep an eye on a broad range of global data in the hopes of seeing the big picture with a bit more clarity.