As clearly explained in the excellent book on the Federal Reserve, Secrets of the Temple, the average person views money as something mysterious, valuable in-and-of itself, even magical.
The job of Federal Reserve, on the other hand, is to create money out of thin air. The Fed members understand that money in its current fiat and now largely digital form, far from being something tangible, is actually something between a social agreement and a unit of measure.
The Fed's job is essentially to manipulate the supply of money (liquidity) in the financial system to achieve its mandate of 2% inflation and maximum employment.
In the book, Animal Spirits: How Human Psycology Drives The Economy, and Why It Matters for Global Capitalism by George Ackerlof (Fed Chair, Janet Yellen's husband) and Robert Shiller, the case is made for the government to lead the economy in a positive direction through aggressive monetary policy with the hope that the fiscal side will support and eventually a virtuous and self-sustaining economic cycle will result.
This is essentially the path that the Federal Reserve has pursued since the 2008-2009 financial crisis. The hope has been that by adding massive liquidity to the system, that lending would be spurred and economic growth would follow.
The reality has been different. The middle to lower end of society has been struggling with stagnant wages and damaged credit. Most do not have access to credit and many of those that do have an aversion to borrowing as they do not see opportunity for growth. The result is that massive amounts of liquidity pumped into the financial system by the Fed do not trickle down to the average person.
Given that we are in a consumer driven economy (70% of the economy is from consumption), the fact that the average person has very little disposable income keeps a lid on any real recovery. This has not been true of stocks. The stock market has roared to all-time highs, largely fuelled by low interest rates and cheap credit available to the upper end of the economic spectrum.
The Fed has repeatedly stated that it cannot successfully carry the weight of an economic recovery by itself. The Fed's actions must be supported from the fiscal side.
In my view, the Fed miscalculated in failing to see the resistance that Congress would give to providing fiscal support to the recovery. This has caused a dramatic divergence between those on the upper end and those on the middle to lower end of the economic spectrum. This is evident in looking at the rise in stocks vs. stagnant wages.
The actual effect of the Fed's stimulus programs (adding liquidity to the top end of the economic spectrum) without fiscal support (liquidity to the middle and low end), has been to put pressure on the majority of the consumer base because the price of assets and commodities have been driven up while real wages have stagnated.
A further evidence of this divergence is the record use of food stamps, now nearly 50 million. While the unemployment rate has declined, so has the labor force participation rate. At least 8 million jobs lost in the crash have not been replaced.
There have been numerous indicators of a slowing economy over the last few months, which the Fed and markets have dismissed as weather related. Should the market perceive that there is actually a slowdown aside from the weather, as is evidenced in the real estate market in the Southwest, the divergence between asset prices and the general economy could become strikingly evident in short order, with a significant decline in stock prices.
It hardly bears mentioning that a very significant factor in this mix is the tapering of asset purchases that the Fed has engaged in for the majority of the time since the financial crisis. The reduction of liquidity in an overvalued market adds to the risk of a decline in stock prices.
The problem now is that we have a high overhang of asset prices lacking support from the consumer and indications of a slowing economy. A drop in asset prices will damage an already shaky consumer and could easily start a self-reinforcing negative feedback loop that could cause serious damage to the core of the economy.
In my view, fiscal support must be provided or asset prices (NYSEARCA:SPY), (NYSEARCA:DIA), (NYSEARCA:IWM), (NASDAQ:QQQ) will drop significantly. It appears that the latter is more likely in the near-term and that we are near the point where excuses for the slowing economy are wearing thin.
Disclaimer: Nothing in this article is to be taken as professional financial advice, nor is it a solicitation to buy or sell any type of securities. All financial decisions are your own, seek professional advice before taking action.
Disclosure: I am short IWM, SPY, QQQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Short via puts.