It’s become increasingly apparent that the Federal Reserve’s policy of keeping interest rates low and purchasing trillions of dollars in securities is doing little to boost the economy.
In fact, the Fed’s actions have encouraged the large banks to engage in strategies that are actually harming the economy and damaging the financial system at the same time.
That’s because banks generally have two options to make money. First, they can follow their traditional practice of making loans available to businesses. But with interest rates at extremely low levels and economic activity stagnant, the profit potential from lending is minimal and risky.
Second, they can allocate resources to their proprietary trading desks to engage in leveraged financial-market speculation. By their nature, these activities are potentially far more profitable, especially when banks (unlike you and me) can borrow practically endless amounts of money from the Fed at interest rates close to zero.
|The Fed’s current policies encourage large banks to speculate rather than lend.|
This means that the Fed’s policies have created incentives for banks to speculate rather than lend. As a result, the economy is deprived of the money it needs to grow, and the banks are able to temporarily improve their earnings by aggressive risk taking.
These policies also cause an artificial increase in stock prices as more and more money is siphoned away from Main Street and pumped into Wall Street.
Determining the amount of money the bank’s proprietary trading desks are diverting to the stock market is tricky business. But the chart below, prepared by Hoisington Investment Management, confirms that it is indeed happening.
The chart shows an unprecedented decline in the money multiplier. The money multiplier is the link between the Fed-supplied monetary base and the money that is actually circulating in the economy. In 2008, prior to the Fed’s massive expansion of the monetary base, the money multiplier stood at 9.3, meaning that $1 of base money supported $9.30 of real money moving through the economy as a result of business activity. Today, the money multiplier has plummeted to 3.1.
If the money created by the Fed’s policies was moving through the economy as it is supposed to, the money multiplier would be the same. However, when the Fed’s money goes to the bank’s proprietary trading desks, the multiplier collapses.
Get this: The September 2013 level of 3.1 is the lowest in the 100-year history of the Federal Reserve. And up until the last five years, the money multiplier had never dropped below the old historical low of 4.5 reached in late 1940.
Stock market investors have temporarily benefited as they have seen their portfolios rise dramatically in value from the 2009 lows. That’s why I warned last week that you should begin preparing now for the eventual stock market correction because the current Fed policies are unsustainable.
I don’t believe the eventual stock market pullback is knocking on the door just yet because there are no warning signs that the Fed’s experimental policies have started to unravel. But as Bernanke, Yellen and Co. continue to try untested theories, unknown risks are almost impossible to identify. So remain vigilant and alert.