The Federal Reserve wanted to boost asset prices after the 2008 financial crisis, but the U.S. central bank and the stock market may have developed a much deeper, unhealthy relationship.
Since the early- to mid-1980s, the S&P 500 Index has generated disproportionate gains on days when the Fed’s rate-setting committee has revealed its decisions, whether they eased or tightened monetary policy, according to new findings from investment firm GMO. This effect became huge in the aftermath of the crisis as the Fed and other central banks bought bonds in a wave of so-called quantitative easing. It has since subsided, but it’s still meaningful compared to typical market days and the non-existent impact of the Fed before 1983.
Overall, days with Federal Open Market Committee meetings account for a whopping 25 percent of the total real returns on U.S. stocks since 1984, according to the research. There may be legitimate reasons for markets to respond positively to the certainty of a decision, but this result looks extreme.
Strip Fed days out, and the punchy roughly 26 times price-to-earnings ratio powering the stock index, as adjusted for cyclical effects by economist Robert Shiller, would fall below 15 times, eyeballing GMO’s chart. Put another way, stock-market prices would be little more than half as high as they are now.
What’s most surprising is how far back the pattern goes. It begins even before Alan Greenspan – who became famous enough for his perceived willingness to rescue stocks with monetary policy that investors coined the “Greenspan put” – became Fed chairman.
The central bank has a mandate that should look past market swings, even if financial conditions are relevant. Yet some members of the FOMC under Chair Janet Yellen have seemed unduly worried about volatility of late, avoiding even modest interest-rate increases for fear of roiling investors.
The GMO results could help explain why. The Fed and the market may be feeding off each other, with market players concluding that everything Yellen and her colleagues do is beneficial, and the FOMC placing too much weight on the market reaction. It’s another reason for the Fed to stiffen its backbone, even if a break in the mutual dependence eventually brings a sobering stock-market slump.