The members of the most powerful financial body in the world (U.S. federal reserve Committee) are spending hours on end obsessing over two words: “considerable time.” I kid you not. You can read the minutes from the last FOMC meeting here for yourself. You'll notice that the longest paragraph by far consists of a debate over whether to remove these two seemingly innocuous words from their official statement.
After keeping interest rates at 0% for an unprecedented six years, one would think that the Fed would be ready to stop saying that it intends to maintain rates at 0% for a “considerable time.” One would be wrong. You see, the Federal Reserve has built a stock market and financial system that has become increasingly dependent on the continuation of 0% interest rates. Any indication of a shift in this policy has made the markets very unhappy, thus requiring a quick dovish fix to satisfy the needs of the easy money addicts.
After a lengthy debate in the last meeting, the Fed members in favor of keeping the language in the statement won out, arguing that the:
“removal of the ‘considerable time' phrase might be seen as signaling a significant shift in the stance of policy, potentially resulting in an unintended tightening of financial conditions.”
What did they mean by financial conditions and how would removing two words from a statement have such a negative effect? Perhaps they are they referring to the Chicago Fed National Financial Conditions Index which measures risk, liquidity and leverage. But that doesn't make much sense, for instead of pointing to stress this index recently stood at its most benign level in history. How could they claim to be concerned about a tightening of financial conditions when financial conditions were about as loose as we have ever seen?
The truth is that by “financial conditions” the Fed is really just referring to the short-term machinations of the stock market. The Fed is afraid that removing the “considerable time” language might lead to a decline in stocks. Such a decline would be troubling to the Fed because it would jeopardize their “virtuous wealth effect” theory whereby higher stock prices are supposedly leading to more spending and higher incomes for all. If the basis for much of your easy monetary policy is this theory, then you cannot allow any decline in stocks because it will lead to an unwinding of the “wealth effect,” or a decline in spending, growth and income.
Let's take a look back at recent history to see how the short-term movements in the stock market have become the key driver of monetary policy.
2010
We'll start with 2010. The economy was one year into its expansion and approaching the point where in every prior post-war cycle, the Federal Reserve would start discussing an imminent tightening of monetary policy. The first round of quantitative easing (QE1) had ended in March and the “financial crisis” was clearly over. In early April, the Fed Funds futures market was anticipating the Funds Rate would increase to over 1% by May 2011 and over 2% by early 2012. In its April statement, the Fed noted that “economic activity has continued to strengthen” and the “labor market is beginning to improve.”
What happened next? We saw the flash crash in May and a 17% decline in the S&P 500 to its low in July.
