Does the Federal Reserve Receive Too Much Blame?

When the economy and the stock market eventually flag, Wall Street has a convenient scapegoat at the ready: the Federal Reserve and its plan to raise interest rates.

The business cycle, though, is going to end whether the Fed raises rates or not. We are getting near the finish line of the current cycle.

I don’t know that this cycle will end before the Fed raises rates, but I believe the central bank can probably slip in at least one or two rounds before it starts to contract. The current speculation is that the Fed will wait until at least September to tighten monetary policy.

Wall Street is hooked on cheap money, which is the product of the Fed’s holding rates near zero since the financial crisis. Perversely, any sign of economic weakness cheers the market, which believes that the Fed will postpone action to avoid hurting the economy even worse. On April 6, for instance, the Standard & Poor’s 500 rose 0.66% in the wake of a poor jobs report.

The investment community’s paranoia about the Fed recently found expression in an ill-informed Wall Street Journal column. It claimed the Fed has already slowed the economy by virtue of its tightening talk. Puh-leez – this is so wrong.

For one thing, the credit markets are booming. Financial conditions aren’t tight, unless you think that a stock market that doesn’t move relentlessly higher is a sign of tightness.

Alex Wong/Newsmakers via Getty Images

Alex Wong/Newsmakers/Getty Images

Mundane realities won’t stop the Street from blaming the bank for the long fall from sky-high valuation levels (although not as high as the tech bubble) to the concrete below. The reason for the upcoming fall is the inevitable end of the business cycle; for the size of that fall, blame the Street’s foolishness in chasing prices to ridiculous heights. But it will blame the Fed for that too, even as it took credit for all the great performance that preceded the slump. It’s just the nature of the beast.

Earnings tremble on the negative, from the looks of the first quarter reports thus far. Thomson Reuters projects that they will rise just 2.1% compared with 2014’s first period. As such earnings are probably not a good springboard for further rallies, I expect yet another pullback in June. Nevertheless, the market’s guiding light is Fed policy and apparently will remain so. The trend is your friend, until the end.

If you want to blame the Fed for something, it’s better to focus on its lack of the firepower needed to combat the next economic downturn. The central bank won’t be able to get rates high enough to provide the Fed with much of a safety cushion going into the next downturn, as Chairwoman Janet Yellen will discover.

But even the ability to cut by two percentage points – which the bank will almost certainly not have – can’t stop a contraction. Monetary policy is a cushion in downturns, not some reality transmogrifier out of Calvin and Hobbes.

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M. Kevin Flynn, CFA, is the president of Avalon Asset Management Company in Lexington, Mass. Website: avalonassetmgmt.com.

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