Previously, I explained how the Fed’s policy of buying and selling securities affects interest rates and stock prices. The largest change in purchases (or sales) of securities occurred between mid-2007 and mid-2008. Then the Fed sold 40% of its securities holdings. This decision brought this component of silver back to 1999 levels. This lack of silver produced a lack of liquidity, a crash in stock prices and a collapse in the economy.
In February 2009, the Fed began buying back securities to restore the currency. The stock market began to rally in March. By April, the Fed had not only completely replaced all of the securities it had sold, but added another $200 billion. In July, the economy started to recover.
Over the next four years, the Fed purchased an unprecedented $3 trillion in securities. This brought its total holdings to just over $4 trillion, the largest increase in bank reserves in history, outpacing the massive increase in purchases of securities used to finance World War II.
At the end of 2014, the Fed stopped its securities purchases. From 2018 to the end of 2019, the Fed sold $500 billion in securities. Such dramatic changes in the holdings of Fed securities would normally have a dramatic effect on stock prices and spending (GDP in current dollars). Instead, from 2009 to 2019, annual spending has been extremely stable, with spending (GDP) growing within a narrow range of 3-5%.
Why didn’t the Fed’s massive securities purchases have a major impact on spending? How come stopping and then selling stocks didn’t put downward pressure on stock prices and expenses?
The answer: most of the money created by the Fed has never been injected into the economy. As always, the Fed’s securities purchases created new bank reserves adding to the currency’s raw materials, also known as great power money. However, for these funds to enter the economy, banks had to lend or invest their new bank reserves. If the banks keep their new reserves on deposit with the Fed, the new reserves do not increase the amount of money in the economy.
It turned out that the Fed’s securities purchases at the start of the recovery were so large that the banks could not find enough profitable uses for the new reserves. As a result, banks left most new reserves on deposit with the Fed. In 2014, banks had $2.7 trillion on deposit with the Fed. These deposits represent potential silver. These are potential money, because once the banks determine that the conditions are profitable, they will grant loans or invest these funds in the economy.
The chart above shows both total securities held by the Fed and bank reserves (bank balances on deposit with the Federal Reserve. Note how banks often increased or decreased their deposits with the Fed. In doing so , the banks were able to offset many of the Fed’s dramatic shifts in its holdings of securities. This stabilizing force is why spending was much more stable than Fed policy alone would have created.
To determine how much of the increase in money reaches the economy, one must factor in the Fed’s purchases of securities (new funds in banks) and subtract the funds that banks leave on deposit with the Fed. (which prevents the release of these funds into the economy).
The following graph shows the net effect of these two factors, which I have arbitrarily named “Liquidity”. Although the banks left a large part of their new funds with the Fed, liquidity increased sharply during the first half of 2020. It then stabilized, before recovering sharply in 2021.
With COVID-19 and the government lockdown, the Fed went on another buying spree. As in its previous frenzy, banks left much of their new reserves on deposit with the Fed. Since the spring of 2020, the Fed has continued to buy securities at a steady rate of 10% per year. Rising bank deposits with the Fed moderated liquidity growth again in late 2020 and early 2021. However, over the past year liquidity has again soared, increasing at double digit rates.
Historic increases in Fed securities purchases can be a powerful force driving stock prices higher. The substantial increases in silver in the economy continued into the start of this year. This increased liquidity is expected to put strong upward pressure on stock prices as well as spending for much of the second half of this year.
While monetary policy continues to push stock prices up, other factors are pulling stock prices down. As stated earlier, equity investors should always consider the underlying fundamental value of stocks. My fundamental equity analysis uses the long-term earnings trend for the S&P500 index and high-quality bond interest rates, which produces an estimate of fundamental value.
In Q4 2021, with the S&P500 at 4,600, my analysis estimated the value of the S&P500 at around 4,160. As a result, S&P500 stocks were selling for just over 10% above their value. Conditions have since changed. In the fourth quarter, interest rates on high quality bonds were 2.6%. Currently, the interest rate is 3.3%. Higher interest rates reduce the value of stocks. At current interest rates, the value of the S&P500 is slightly below 4,000. Stock prices and value have fallen, leaving stock prices about 10% above their value.
Rising interest rates over the coming year is a key issue that impacts the future value of stocks. For example, if bond rates were to rise by one percentage point, the fundamental value of the S&P500 would drop to 3,800 in the fourth quarter of this year.
Current economic forces are pulling stocks in different directions. While the influx of money into the economy pushes stock prices up, a widely anticipated rise in interest rates pushes stock prices down.
At the start of this year, the forces that drove stocks lower won this tussle. If monetary policy were to swing from expansion to contraction, as it did in 2008, it would cause serious problems for both the stock market and the economy.
The opinions expressed in this article are the opinions of the author and do not necessarily reflect the opinions of The Epoch Times.