Stock Markets Fear the Fed More than War

The stock market does not fear nuclear war. It fears a Fed not responsive to its every need, but does not care about nuclear war. There are two solid reasons for this. And we have a scenario in which this brinkmanship played out, the 1962 Cuban Missile Crisis.
Lars Christensen coined the phrase "Market Monetarist" and claims to be one. He wrote an interesting article about the Cuban crisis. I remember the crisis. I was 13 years old. It left a mark on me and on most who lived during that time, because no one knew that the Russians and Americas would back off from nuclear destruction. The blockade of Cuba seemed to portend the imminent destruction of the world.
Christensen said this about the crisis, implying that the Fed was more lucky than good in keeping a floor under the stock market:
In 1961 US NGDP growth had been accelerating significantly – with NGDP growth going from only 0.5% y/y in Q1 1961 to 9% y/y in Q1 of 1962. That reflects a rather massive monetary expansion. However, from early 1962 a monetary contraction took place and NGDP growth started to slow significantly. This I believe was the real reason for what at the time became to be known as the Kennedy Slide in the stock market. This was prior to the Cuban missile crisis.
However, as the geopolitical crisis hit the Federal Reserve moved to ease monetary policy – initially not dramatically but nonetheless the Fed moved in a more accommodative direction and NGDP growth started to accelerate towards the end of 1962 – a few months after the end of the Cuban missile crisis. I am certain this helped keep a floor under US stock prices in the later part of 1962.
Only now, Putin is putting warships into the Mediterranean Sea. As the United States was willing to establish an act of war, the blockade, so too could Putin initiate an act of war, even firing on American targets. It all depends where, in his mind, his line is drawn in the sand.
We are closer to the end of the world, in many respects, than we were in 1962. The United States has a turbulent and unpredictable president. Russia is ruled by a man of steel, whose patience may be running out.
The Fed, as Christensen says, did well towards the end of 1962 but made mistakes after the crisis, towards the end of the '60s. That could happen again. Jeffrey P. Snider has said that the Fed is not providing enough liquidity for the world.
 As Jeffrey P. Snider has said:
It isn’t recession but far worse; another angle by which the vise of depression slowly but persistently squeezes the avenue for what little opportunity might still remain in this economy. If the auto sector goes, what truly is left as a basis for something actually different in the positive direction? It actually adds to further hysteresis weight for whatever might come next, including all those Trump policies that were supposed to at least be defined by now. In other words, if consumers who splurged for years under central banking have now come to view it more skeptically, they will in all probability evaluate future prospects from here on under the same uncertainty.
People need to realize that the Fed takes down the economy in one way or another as wages creep up. The Fed seems to be fixated on wages. Or else, how does one explain the following chart, where recession follows wage gains almost like clockwork?

If we look at the above chart, we see that almost every time the share of GDP spikes for workers, we get a recession. 
An article from Matthew Yglesias is revealing. The author says that the decline of wages compared to GDP is the result of price stabilization policy. 
It turns out that controlling inflation means controlling wages. In the Great Depression, Fed liquidation was severe. It was severe in the Great Recession but turned around more quickly. It is moderate but hurtful in the many recessions where, you guessed it, wages were starting to rise. The '50's and most of the '60's were prosperous for workers. Wage based recessions occurred then too. Worker share of GDP has been in decline since.
Wall Street has benefited greatly from the destruction of wages for the middle class. And if that was not enough, it offered home loans doomed to failure to take wealth too! That happened in the S&L Crisis and the housing bubble of the last decade.
Ray Dalio and Jamie Dimon have said that there is something wrong with the economy. Well, you could start with this problem of the grinding away of worker prosperity.  Derivatives and collateral and the new normal of lower potential growth in GDP simply make the solutions harder to come by.
The stock market declines if the Fed wants to seriously liquidate. We can see wages rising in 2014. If this continues, it could cause the Fed to pull back. It is already raising rates and talking about reducing the balance sheet. If investors are worried about something nuclear, it is likely that the bomb will come from the Fed itself.
The Fed publishes a paper showing that it has collateral for all Fed base money in circulation. Base money is backed by collateral. The Fed will never totally empty its balance sheet. But to get rid of a large portion of it would be the opposite of stimulus. It would be deflationary. If the Fed were to do this at the time of a conflict with Putin, that could cause a crisis.
Edward Lambert, who sees effective demand, has thoughts about Fed behavior over time. He is concerned about bumping up to the Effective Demand Limit. But even in his model, there are deflationary pressures working and have been for some time. For Lambert,
Effective Demand is not a short-run shock. It is based on the relative strength of labor share to profit share. A lower labor share sets a lower limit upon potential output. And the drop in labor share is not short-term. It has been constant for years since the crisis.
Lambert believes that low labor share is responsible for low inflation. 
Even Mises comments on this deflationary Fed:
Unfortunately, despite the confusion it has wrought, the putatively low natural rate serves as a ready-made excuse for the Fed to continually delay raising the fed funds target rate lest it push the interest rate above the natural rate, suppressing investment and consumption spending and plunging the economy into deflation and depression.

Market Monetarist Scott Sumner believes that the actual rate being above the natural rate is deflationary, and that money is too tight:


I must be missing something really basic, as I would have expected exactly the opposite result. Since 2008, the inflation rate has usually been below the Fed's 2% target, and if you add in employment (part of their dual mandate) they've consistently fallen short. This means that money has been too tight, i.e. the actual interest rate has clearly been above the Wicksellian equilibrium rate. But they find exactly the opposite result. Why? What am I missing?
Whether that statement is true or not, more people are worried about deflation than inflation, except for the Fed, it seems. We should look once again at the Great Recession more carefully through the eyes of Snider.  He spoke of the Fed balancing markets that needed tightening or more liquidity at the same time:
At that point in 2007, and again at the worst points in 2008, there were contradictory signals from all over the place – LIBOR rates screamed out for more liquidity, federal funds for less; repo for collateral not “reserves”; commodity prices indicated badly needed “tightening”, while debt markets from commercial paper to the more esoteric MBS structures blurted desperate warnings. What would a commodity target faced with these contradictions (as well as others I haven’t included; those where the real fun begins) have accomplished? Would it have meant the Fed further depriving markets of “liquidity” just as certain parts of these markets needed them the most?
Snider continues:
 From a broad, decentralized base, solutions can be found, determined and implemented even if we don’t know how or where they come from (think quasi-money that from time to time appears when money is short and central banks show again their vast limitations). From a narrow, centralized base, if it doesn’t work there aren’t any solutions; 2008 showed there aren’t even any other ideas. In whatever comes next, it should be free of any targets, whether interest rates, inflation, commodity prices, or, the worst, least-defined (in terms of all the “how’s”) idea of them all – NGDP targeting. 
And Matthew Yglesias is not saying inflation is necessarily good. But this asymmetry is a reality that is hurting main street and if the Fed liquidates, I think it should provide liquidity to small business and/or helicopter money to the masses in a down turn. Yglesias is pointing out the Fed's unbalanced success which has meant failure for main street:
The labor share declines during recessions and rises during booms. And the problem of the Federal Reserve is that over the past 30 years, it has a perfect track record of never allowing inflation (which is to say a sustained period in which wages rise faster than productivity), but it doesn't have a perfect track record of never allowing recessions. The inevitable consequence of this asymmetrical success is for the labor share to steadily decline.
That appears to be a deliberate fraud upon the workers who are continually beaten down. Workers are learning that wages are pruned relentlessly Perhaps that knowledge of this new normal could have an ultimate impact on Wall Street far greater than we could ever see from a few shots fired at each other by the two superpowers.

This article was first published by me on Talkmarkets: http://www.talkmarkets.com/content/economics--politics-education/stock-markets-fear-the-fed-more-than-war?post=130717&uid=4798














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