The stock market downturn this summer was mostly seen as an effect of the slowdown of the Chinese economy and that country's stock market crash, but Federal Reserve policy likely also played an important role. That's because the stock market was dealing with the reality of no more quantitative easing and facing a return of the Fed's short-term interest rate target to more normal levels.
In late 2008, the Federal Reserve under Ben Bernanke, the chairman at the time, began buying large amounts of mortgage-backed securities, initiating the first round of quantitative easing. Around the same time, policymakers lowered the rate that large banks charge each other on overnight loans to nearly zero. The moves were aimed at stabilizing and stimulating the economy during the Great Recession and countering the negative impact of the financial crisis -- essentially, lack of credit.
As the Federal Reserve continued with multiple rounds of quantitative easing, buying not only mortgage-backed securities but Treasury bonds and agency mortgage-backed debt, it increased the money supply and encouraged banks to make loans. With de facto cash from the debt they had sold the central bank and low borrowing costs from the near-zero interest rate target, banks could make business loans and keep the economy from contracting.
The increased money supply caused investors to look for a place to put their money. With interest rates so low, the stock market seemed a more attractive opportunity than debt, and so stock prices rose, which in turn increased investment earnings among households that held stocks. It can be argued that quantitative easing worked over the short term: It fostered investment; helped GDP grow; boosted the stock market; increased household wealth among families with significant stock investments; and even reduced unemployment.
But these very policies put the Fed -- and the financial markets -- in a very tough spot. That's because the end of quantitative easing and the raising of interest rates to more normal levels carry huge risks of destabilizing the financial markets and erasing gains the policies made.
The problem is that eventually such loose monetary policies must end. Otherwise, the risk is that they create runaway inflation, destabilizing the economy in another way. Over the past seven years, the stock market has essentially become addicted to the Fed's monetary stimulus, and the saying "Don't Fight the Fed" had become commonplace. Such reliance on such an historically extreme policy means that an ending of the policy can function as a needle, piercing the market's bubble.
In early 2014 the central bank began "tapering" its bond purchases and ended them in late October of that year. Federal Reserve policymakers also began preparing the public for an eventual increase in interest rates, with the expectation that one would occur sometime this year. The upheaval in China's economy and markets caused the central bank to hold off on raising rates at its September meeting, but recent statements from policymakers indicate a December hike is a very real possibility.
The markets arrive at this point as other concerns remain, including continuing economic problems in China and other emerging-market nations, and a still fragile recovery in Europe even as the continent attempts to cope with terrorism and a refugee crisis.
Against this backdrop, the Fed's inevitable interest rate hike is likely to inflict pain on the stock market and investors. Worse, restoring interest rates to more historically "normal" levels after they were so low for so long could deal a blow to the economic gains that the Fed's policies have already achieved. A declining stock market is likely to put a dent on consumer spending. What's more, the Fed will face whatever new challenges emerge in coming months with a bloated balance sheet from years of dealing with the effects of the financial crisis.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.