Stocks and the Federal Reserve -- Necessary Pandemonium

Let me be clear from the outset: The Federal Reserve has not only been justified in its aggressive stance toward monetary policy over the past five years, it's also been effective.

Fears of inflation were wrong. Completely. Price appreciation isn't too high; the problem is that it's too low.

And the idea that the benefits of the central bank's policies -- namely, the three successive rounds of quantitative easing -- were outweighed by their detriments, exhibits abject ignorance about the source of our economic malaise. By driving down long-term interest rates, the Fed allowed tens of thousands of homeowners to refinance their mortgages, and thereby free up income for consumer spending. The latter, mind you, accounts for more than 70% of our gross domestic product.


You can see this in action by reading the quarterly reports of any of the nation's largest banks. In the first quarter of this year, for example, Wells Fargo underwrote $109 billion in mortgages, the vast majority of which were refinances. The same was true at Bank of America, though to a slightly smaller degree, given that it originated a total of only $24 billion in home loans over the same three-month period.

But that being said, people who argue that the Fed's policies don't have negative side effects are also deluding themselves. When you inject $2.5 trillion of liquidity into an economy, it's going to inflate asset prices, which is exactly what happened.

Between the beginning of last September, the same month the Fed announced QE3, and the middle of this past May, the Dow Jones Industrial Average and the S&P 500 climbed by 18% and 19%, respectively. And if you want a more extreme example of this, just cast your eyes across the Pacific to Japan, where the benchmark Nikkei soared more than 80% since the government rolled out a similar, albeit more extreme version of the same thing.

Why are higher asset prices a bad thing? In and of themselves, they aren't. One could even make a convincing argument that they've been good. The accompanying wealth effect makes consumers feel more confident and, therefore, willing to, well, consume -- which, again, as I've already noted is the bedrock of our economy.

Where we run into issues, however, is on the downside, triggered by the inevitable pullback in monetary easing. And this is where the necessary pandemonium referenced in the title comes in.

As you can see in the table below, in June, the first full month after Fed Chairman Ben Bernanke intimated that the central bank could soon begin to taper its $85 billion in monthly bond purchases, things went haywire. The average daily movement of the Dow nearly doubled to 136 points, and the blue-chip index either advanced or declined by a triple-digit margin in 80% of the trading sessions.

Month

Percent of Days of Triple-Digit Moves on the Dow

Average Daily Move

January

5%

61

February

37%

77

March

10%

54

April

32%

74

May

36%

73

June

80%

136

Source: Yahoo! Finance

The big question now, of course, is what does this mean going forward?

To be clear, the Fed hasn't said that it will taper its bond purchases, only that it may soon begin to do so. Consequently, once it does finally make that decision, which could happen at any time now depending on how the economy performs, I think it's safe to assume that volatility could even pickup further. And it's for this reason that investors would do themselves a favor over the next few months by temporarily misplacing the password to their brokerage accounts, as buying and selling in this type of environment will almost invariably lead to substandard performance.

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The article Stocks and the Federal Reserve -- Necessary Pandemonium originally appeared on Fool.com.

John Maxfield owns shares of Bank of America. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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