The Federal Reserve's Obligation to Support Stock Prices

The Dow Jones Industrial Average is setting a new record almost every day.  Stocks are up 10% in 2013, and the year isn't even three months old.  Since the recent closing low on Nov. 15, 2012 of 12,542.38, the Dow has risen over 15%.  Stocks are on a tear and fresh money is coming into a market that's going up at an annualized rate of 50% or more.

A principal reason for the hyperventilation in the markets is the Federal Reserve's ultra lax monetary policy.  Even though unemployment has fallen from over 10% in 2009 to 7.7% now, and the economy has resumed moderate growth, the Fed has spent the last four years swinging its scythe far and wide to cut down any positive interest rates that might sprout up.  At the same time, it has printed shiploads of money through its quantitative easing policies.  An abundance of cash, having few other alternatives, has flowed into stocks.  At this point, the market depends on the Fed to maintain and increase its accommodation.  Moral hazard abounds.  Investors have put their precious savings in stocks relying on the Fed's promise to practically give away money for a really long time.  If the market falters now, the Fed will have to step up and accommodate some more, enough to prop up stocks.  It can't allow investors to suffer a third evisceration of their portfolios in less than 15 years.  If the market stages another major downturn, investor and consumer confidence will surely collapse, sending the U.S. into another recession and putting the U.S. financial system under enormous stress. The stock market has become Too Biggest To Fail.

Of course, the Fed would deny that it has any obligation to support stock prices.  Legally speaking, that's true.  But the U.S. Treasury had no legal obligation to support Fannie Mae and Freddie Mac, yet it nationalized them in order to prevent a collapse of the financial system.  The Treasury Department had no choice, given that the market had implicitly assumed that Fannie and Freddie were federally guaranteed.  By relentlessly inflating stock prices, the Fed has put itself in a comparable position.  It has implicitly guaranteed that stocks will not suffer a major collapse. 

The Fed is already honoring its implicit guarantee.  It's stated that the most recent round of QE (call it "QE Unlimited") will go on until unemployment falls to 6.5%.  The market has risen about 10% since the Fed announced this target.  A gnawing risk of the Fed's current policy mix is inflation, and the Fed has said it will step back if inflation flares.  But the question is whether it actually will.  Having drawn investors back into stocks after the market crash of 2007-08, the Fed may hesitate to take away the punch bowl if doing so will precipitate another bear market and recession. 

 Of course, it can't leave the punch bowl at the party forever.  But, given the pickle it's currently in, it may let the party go on too long.  We are at a crossroads in the history of central banking.  If the Fed pulls off its current maneuvers and nurses the economy back to health while keeping inflation in the 2% range, it will have established the paradigm for monetary management of the economy for decades and perhaps centuries to come.  If it fails, however, central banking as we now know it will likely become a thing of the past.