The Fed is not moving the stock market or the price of credit

In a meeting with pollster Brett Lloyd last week, he said a number of U.S. Senate seats were tilting increasingly toward the Democrats. After which, House seats are much more at stake than is normally the case in midterm elections where the occupant of the White House is rather unpopular. That’s something to think about, especially with the stock market in mind.

The conventional wisdom of the past week has been that Fed Chairman Powell’s “hawkish” comments in Jackson Hole were the driving force behind the much-talked-about pullback in the stock market. Readers would be wise to dismiss this wisdom because it is rooted in a misunderstanding of how markets work.

Surprise is the source of great market movements. It gauges real thinking as applied to Powell’s comments simply because there was nothing surprising about them. Powell’s conventional thinker has long been known to believe that the answer to what economists call “inflation” is increased intervention by the entity (the Fed) that has the power to control “inflation.” Powell is conventional, which means he is predictable. He didn’t say anything new to Jackson Hole.

Which means we should look elsewhere for the sudden change in markets. The guess here is that it’s political. For a very long time, it was known that Republicans would enjoy big House gains in November and likely take the Senate.

About what’s been written about projected Republican gains, it’s not a bouquet thrown the GOP’s way so much as a commentary on what the markets seem to like: history says they like the inactivity in Washington. With reason. Any legislation, whether good or bad, can have destabilizing qualities that investors need to assess. Conversely, bottling removes what is happening in Washington as a threat to the market. Long-anticipated Republican gains would exist as a drag on government intervention.

Except that the presumed electoral restraint on the government is no longer as safe as it once was. See Brett Lloyd above. If so, imagine a President with nothing to lose to Biden working with Democratic majorities, or a Democratic Senate in concert with a Republican-controlled House won by the slimmest of margins. This likely changes the legislative landscape by involving interventionist legislation. Markets are personified information and relentlessly evaluate possibilities. The surprise isn’t the Fed, but it would be a big surprise if an unpopular president actually wins a midterm term.

Bringing it back to the Fed, the fact remains that what it’s doing just isn’t that important. Consider a recent opinion piece by the very excellent Judy Shelton. She is a critic of the Fed with good reason, and the central bank is worse off without her. What is a monument to GroupThink could have taken advantage of Shelton’s contrary ways.

At the same time, Shelton came across as less upsetting in her latest. She argues that “the Fed could crush demand by raising interest rates to stratospheric levels,” but Shelton knows that reduces to absurd what is an impossibility. Not only will this most conventional central bank not raise rates to “stratospheric levels”, but neither will it be able to. The Fed can’t make credit more expensive than the mayor of New York can make apartments cheap. The markets always and everywhere have their say, and this is especially the case with credit. Imagine it being produced all over the world, how production is a money magnet that moves production to its highest utilization. Market players would quickly and easily circumvent stratospheric rates which, by their very description, would signal an artificiality that the markets are expert at correcting.

From there, Shelton writes that the Fed’s inflation fight (supposedly higher central bank rates dampen inflation) could be erased “by fiscal measures that increase purchasing power – cash payments, grants, rebates, cancellation of student loans”. Except Shelton knows that’s not true. She has long huddled with the crowd on the supply side, which means she is well aware that there is no way the government can increase demand. It cannot because the government is not an “other” so much as its purchasing power (including its ability to cancel debt) is a consequence of its rights over the present and future production of the American people. In other words, the government’s ability to distribute purchasing power stems from the fact that producers see their purchasing power reduced. There is no increase in demand per se. While government spending is a horrible tax, and arguably the most crushing tax in economic terms, it is not inflationary.

There is no disagreement with Shelton that the goal should be to reduce the burden on government and that “greater production should be the goal”. Definitely. If we reduce the government’s allocation of valuable resources, we will get more production, or more “supply”. To be clear about supply, it will not be more “deflationary” than a lack of supply is inflationary. The balance between supply and demand, as Shelton well knows, is why it didn’t ring true in his assertion that current inflation is “largely due to a lack of supply.” Reduced supply equals reduced demand.

All of this begs a fundamental question: why is Shelton so restrained in her commentary? She knows what inflation is: it is a drop in the unit of measurement used to facilitate trade. Translated for those who need it, inflation is monetary devaluation. Which means the answer to inflation is not more supply, it’s not less government spending, it’s just a stable dollar. Except that the dollar exchange rate has never been part of the Fed’s policy portfolio. Shelton knows that too.

The Fed just isn’t that important. Neither from a stock market perspective, nor from an inflation perspective. Eventually, this contrarian view will become mainstream.

Eleanor C. William