Central banks do more than set interest rates in an attempt to guide the economy. They also push and prod market psychology to move the economy in the direction they think best. Easy money and low interest rates send messages to take risks, spend money, boost a slow economy and be confident that the central bank might help out. Tight money and rising interest rates send the reverse messages: be wary, pull back, don’t over heat the economy, don’t push prices up. This game of market psychology has been nick-named Risk On-Risk off.
The game isn’t new. It dates at least back to a Scottish economist, John Law (1671-1729) who defied the reputation that the Scots are skillful at managing money when he introduced a version of central banking to France with disastrous results. It was all Risk On, but Law managed to evade the consequences for a time. A more modern analysis comes from another economist, Hyman Minsky (1919-1996). Minsky’s saw economic growth, rising securities prices and government support and bailouts as encouraging optimism and risk taking. As the good times roll, markets forget their fears. Forgetfulness leads to Risk On all the time. The Great Moderation (1982-20070 of rising stock and bond prices, low unemployment and low inflation set the stage for the financial crisis. Banks became leveraged to the extreme and people borrowed money with no idea of how they would repay the debts. The result was the financial crisis of 2007-8.
We may have too much Risk On optimism and not enough Risk Off fear today. As widely noted, volatility is very low, VIX seems stuck in the basement and similar volatility measures for non-US equity markets, oil and other investments are similarly low. Stock prices keep rising, defying both the skeptics and the bears. Common sense suggests that VIX can’t fall and the S&P 500 and the Dow can’t rise forever — but experience keeps challenging this. Herbert Stein, another economist, commented, “If something can’t go one forever, sooner or later it will end.”
How will it end? Certainly no one knows either the How or the When. The S&P 500 could sail through 2000 to 2500 or beyond or collapse as it did twice in this young century. Out of the infinite possibilities consider two:
A collapse and sharp drop cannot be ruled out. Some of the tech stock stories heard today are eerie echoes of March 2000. Technology is again the largest sector in the S&P 500, but far below the third of the total index seen some 14 years ago. Moreover, the index itself is less top heavy than it was then.
Things could crumble. The Fed has hinted that sooner or later it will raise interest rates and a minority on the FOMC is leaning in that direction. In just about every major reversal of Fed policy, analysts knew it was coming but were surprised (shocked?) when it happened. When the Fed raises interest rates, markets are likely to drop. It could be a bigger bang than the tapering announcement in May 2013.
While the Fed’s monetary policy since 2009 has been largely successful, no one will argue for perfection. The same is true of its ability to guide market psychology.