The modest correction of the past two weeks bears some comments. On May 9th, the major indices were at 6 year highs with the Dow 80 points from an all-time high and the S&P 500 13% from its all time high. On May 10th, the US Federal Reserve Bank raised the funds rate to 5.0%, the 16th increase in 16 meetings. The increase was universally expected, but investors hoped to hear that the Fed was done, or nearly done. Those investors were disappointed. Over the next 7 sessions, the S&P 500 gave up 4.8%, the Dow 4.4% and the NASDAQ fell 6.8% taking that index negative on the year and to the lowest level since November 7th, 2005.
Is this a temporary pullback, or the start of a new bear market? How can we tell the difference?
Federal Reserve Policy
To start with, why are investors so glum about Federal Reserve policy? The job of the Fed is to promote stable, non-inflationary growth in the US economy through application of monetary policy. The Fed has two tools to facilitate this policy – the first is the well known setting of the Funds rate. Higher interest rates make certain projects that businesses might consider less attractive. For example, a condo builder might be able to develop a property if the cost of borrowing is 6%, but at 8% the cost of borrowing might exceed the profits of the project, therefore the condo doesn’t get built. It’s less known that the Fed also controls how much money is available for loans through open market operations. If the Fed wants to reduce the amount of money in circulation, it will “sell” government securities to banks at attractive yields, with agreement to “buy” these securities back at a later date. These contracts are called “repurchase agreements.” If the Fed “repos” a high volume of treasuries out to the banks, that money is no longer available for lending.
Since the 1970’s the Federal Reserve has gotten ever more sophisticated at using these tools to provide the right amount of liquidity (through rate setting and money supply) growth to the US economy to maximize non-inflationary growth.