Given the events of the past couple of months, interest, money, and the future of asset allocation is beginning to change. To better understand the conditions we see today, we must go back to the extension of the Housing and Community Act of 1992 which incentivized banks to come up with innovative ways to make houses more affordable to vulnerable populations. The banks responded by popularizing mortgage-backed securities (MBS), which created a massive housing bubble that ended pretty badly as we all remember. During the financial crisis, the Federal Reserve sought to lower interest rates, increase the money supply, extended its discount window program to central banks, and bailed out other banks in a desperate effort to flood the economy with the currency that was needed to quickly re-start the economy.  But why? You see, neo-classical economics and monetary theory agreed that lowering the Federal discount rate should promote more borrowing from central banks, which then should have made it easier for private banks to borrow money from central banks, which they could then use to lend to companies at lower interest rates.

From the chart above, we can clearly see how lowering interest rates increased the money supply, and thus should increase the demand for money in the short-run. As the demand for money increases, an increase in investments should follow. Unfortunately, this also implies that inflation levels should have risen as we trade off growth for inflation.  Given the amount of money put into the system, we can clearly see that this theory started to work flawlessly during the beginning of 2008 and thus, the economy should have recovered quickly after that. As this happened, the banks began to borrow enormous amounts of money, and the market speculated that higher levels of inflation were soon to follow.

After 2008, many people feared that such a massive increase in the money supply would create rapid amounts of inflation as more businesses borrowed cheap money at the same time that interest rates were reaching zero. The idea at the time was that this enormous sum of money would create growth in the US economy, which would translate into more jobs, but also more inflation. As time went by, nobody could explain why the U6 and U3 unemployment rate decreased as inflation remained flat, despite all of that money that was added to the economy. In 2008, some investor’s even feared hyperinflation as they thought the economy was going to be overstimulated. When inflation didn’t reach the target of 2% year after year, the market knew something had gone terribly wrong.

What Happened?

Although many argue that inflation didn’t surge in the US economy because of anemic growth and over-regulation, that’s only part of the story. Let’s remember that the money demand theory promised an increase in money supply (that did happen), along with an increase in money supply and demand for money as interest rates decreased. It never promised that this effect would occur in the real economy. You see, the assumption was that the money put into the banking system would quickly enter the real economy and spur inflation. Instead, a lot of that money was never loaned while some went into wall street. However, this doesn’t mean that theory was incorrect, after all, there were a lot of rules and constant changing regulations that prevented this money from being lent out, the biggest being the Dodd-Frank Act of 2010.

If you look at the money demand theory from an investor’s perspective, it signals that bonds were going to get pricier as rates went down since there’s an inverse relationship between price and interest rates. For example, as interest rates go down, the price of bonds go up. As a result, lower interest rates increased the price of bonds. Since Bonds and Stocks are often held in portfolios and measured against risk, if the value of bonds diminishes due to an increase in price, then it’s only natural for investors to switch to stocks as they seek to maximize their utility. This should have created a surge in the stock market as we moved from point A to point B, and it did.

In order to better understand why this happens, we can look at the Security Market Line (SML) that explains that for every unit of expected return, investors incur an extra unit of risk according to Efficient Market Hypothesis (EMH). Why would investors take on more risk? Because they have to invest in assets that are correctly valued, taking into account opportunity cost, risk, and total returns.

In summary, not only can old theories be used to explain Ben Bernanke’s plan to restore the economy after 2008, but there’s also significant proof that it did work to some degree. There was admittedly inflation in the stock market if we define inflation as a rise in prices only accompanied by lower value of those assets. The evidence can be seen by higher than expected P/E ratios which signals overvaluation of stocks as investors pay more for earnings. As we all know, money has to travel somewhere once it reaches a market, and it seems that a lot of that money went into the stock market and never reached the real economy, which is known as Financialization.  This also implies that the real reason why the economy recovered very slowly (if at all) was because it never got any real help.

Now what?

Since we are now entering a world of higher interest rates and inflation, it is only obvious to think that Bonds will start to become more attractive again. However, that doesn’t mean that the stock market will go down or crash, it only means that returns on an annual basis will be lower compared to periods of lower interest rates. As we shift from B to A, it will be important to remember that major stock indexes such as the S&P 500 will not perform as well when compared to lower interest rate periods. As always, some industries will outperform the market.

References:

• Flynn McConnell Brue Microeconomics [Book]. – New York : McGraw Hill, 2015. – Vol. 20.
• Mankiw N. Gregory Principles of Macroeconomics [Book]. – Stamford : Cengage Learning, 2015.
• Nicholson Walter Microeconomic Theory [Book]. – Willard : Thomson South-Western, 2005. – Vol. 9.