Last week, the publisher of Grant’s Interest Rate Observer sat down with Reason magazine to discuss the financial world’s recent turbulence. When asked how much of the stock market’s recent rally was real, Grant argued some of the gains investors have harvested in recent years are based on fundamentals. But most of it, he says, is the result of the Fed’s easy money policies. (Source: Jim Grant: The Fed Turned the Stock Market Into a ‘Hall of Mirrors’, August 26, 2015.)
“So some of this is natural corporate profits have risen,” he told the libertarian publication. “There has been a kind of recovery from our sorrows in 2008.”
“But superimposed on all of that has been the artificial government levitation of asset values. This has been the plan, to raise up the prices of stocks, bonds, real estate.”
But it gets worse. Not only have low interest rates created a bubbly stock market, they have created huge distortions in the real economy as well.
“By lifting stock prices, ah, excellent. [You’re] Lifting of junk bond prices,” Grant continues. “Except, behind those prices is real enterprise. Real people making real choices about how to allocate capital. When you get fake interest rates, you get misdirected flows of investment, enterprise, and effort.”
Low interest rates tend to stimulate borrowing, Grant explains. The newly issued credit leads to a stock market boom and a splurge of new capital spending. However, most of these new funds are ploughed into poorly-thought-out projects, or “malinvestment.” The “bust” occurs when the credit creation has run its course, causing resources to be reallocated back towards their former uses.
For investors, the consequences of the Fed’s policies are catastrophic. Low interest rates push stock market valuation to bubbly heights. But when the easy money taps are pulled shut, shareholders could witness an epic stock market crash.
“We are living, to a degree, in a kind of hall of mirrors. The poetry is attempting to find out how much of it is real and how much of it is this governmental wiped cream.”
The classic jazz song It’s Only a Paper Moon provides a fitting metaphor. It wouldn’t be make believe, if only everyone believes in it. The second the public stop believing in the illusion, the whole recovery comes crashing down.
What should the Fed do? In Grant’s view, we need to allow the market to set interest rates. Only when the Federal Reserve halts its manipulation over the price of money will the market be able to correct its mistakes.
“What we need are natural, organic, free-range interest rates. Sustainable, local interest rates. The kind they grow spontaneously in the market. Not the supermarket hothouse kind the Federal government imposes.”