The Federal Reserve Is Still The Stock Market's Best Friend – Seeking Alpha

The Dow Jones Industrial Average broke 25,000 today. The historical records the Dow, the S&P 500, and the NASDAQ are coming along almost daily.

I have been arguing for several years now that in the current bull market associated with the current economic recovery of eight and one-half years, the monetary policy of the Federal Reserve is the stock market’s best friend.

As things look right now, this will continue to be the case into the near future.

There seem to be three things that are dominating people’s thoughts on the future of monetary policy.

First, it is expected that the Federal Reserve will raise the range of its policy rate of interest by 25 basis points three times in 2018.

Second, the Federal Reserve will continue to reduce the size of its securities portfolio during the year.

Third, there will be a substantial change in the policymakers that make up the voting members of the Fed’s Federal Open Market Committee, the FOMC. The FOMC is the body within the Fed that determines what the monetary policy of the U.S. central bank will be.

In February, a new Chairman of the Federal Reserve, Jerome Powell, will take over. Mr. Powell, however, is an existing Board Governor at the present time.

Mr. Powell will be joined by Lael Brainard, an existing Governor, who was appointed by President Obama. The other existing Governor is Randal Quarles, who was appointed by President Trump.

Mr. Trump has also nominated another person to be a Governor, Marvin Goodfriend, but, Mr. Goodfriend still has to receive Congressional confirmation.

With current Fed Chair Janet Yellen stepping down in February, that leaves three other vacant seats on the Board of Governors that President Trump has the opportunity to fill.

Furthermore, there are three presidents of Federal Reserve district banks that must be replaced this year, one being the president of the Federal Reserve Bank of New York, who is a permanent voting member of the FOMC. It is assumed that the Trump administration will take a major interest in who the appointments are for these positions.

The bottom line of this discussion is that most of the Board of Governors of the Federal Reserve system, five of the seven to be exact, will be appointments of President Donald Trump. And, this does not include the fact that Mr. Powell, a sixth Governor, has been nominated to become the Chairman of the Board.

It is this third point that will dominate what happens within the Fed this year. Most believe that even with the change in personnel that the Fed of 2018 will act much like the Fed of 2017 in terms of what, I believe, is the most important characteristic of the 2017 leadership team.

The FOMC, under Janet Yellen, has raised the Fed’s policy rate of interest during her tenure as Chair, but has always acted so as to err on the side of monetary ease so that no dislocations take place in the banking system similar to the one that occurred in 1937 when Fed officials raised the reserve requirements on commercial banking deposit accounts.

It has been this “ease” that has supported the confidence of the stock market and has resulted in the almost continuous rise in stock market prices over the past nine years.

If anything, I believe that the Trump appointees will be even more likely to err on the side of ease than the Yellen FOMC was, and, if anything, will be more reluctant to raise the Fed’s policy rate three times this year or stay on the Fed’s intended schedule for reducing the size of the Fed’s securities portfolio. Thus, commercial banks will be able to operate in the coming year confident that they will have sufficient liquidity to meet their adjustment needs.

This last three months, the time period in which the Fed has begun to reduce the size of its securities portfolio, has been a good example of this. From the Fed’s H.4.1 statistical release, we see that since September 27, 2017, the Federal Reserve has reduced the size of its securities portfolio by $22.8 billion.

During this time, however, reserve balances at Federal Reserve banks, a proxy for excess reserves, have remained roughly constant – actually increasing by a modest $15.9 billion.

Fall is a very difficult time of the year because commercial banks experience currency drains as the private sector draws money out of the banks to pay for holiday goodies. In addition, the Federal Government experiences massive movements in funds in and out of the banking system during this time period.

The Federal Reserve has managed these operating factors very well over the past three months and has overseen the reduction in its securities portfolio without undue disturbances.

This Federal Reserve action has provided confidence to investors, a good thing, which, I believe, has supported the rise in the stock market during this time period. The Fed position, however, has also resulted in a weaker U.S. dollar in foreign exchange markets.

Overall, this has been good for the economy because, the rising stock market and the falling value to the dollar has raised business confidence, and, along with the recently passed tax bill, has provided a very good economic scenario for the start of this calendar year.

As I have suggested earlier, the market to watch in coming weeks, or, months, is the bond market. Longer-term interest rates have remained low in 2017 because inflation has remained low and investors appear to believe that the structure of the economy has changed in a way that will allow inflation to continue to remain low for the foreseeable future.

If expectations for inflation remain low, longer-term interest rates will continue to remain low… and there won’t be any problem coming from this area.

However, if inflationary expectations begin to rise, longer-term interest rates will also begin to rise and this will result in more and more pressure for the FOMC to raise short-term interest rates even faster than they now plan. This scenario, I believe, could be the financial market disruption that would change bets for both the stock market and for the value of the U.S. dollar.

As stated in my post, I believe that investors need to keep an eye on the bond market for hints that substantial changes in inflationary expectations might be on the way.

Looking forward and assuming that these inflationary disruptions do not take place, I am confident that the “new” Federal Reserve Board of Governors will do very well. There is no better professional staff anywhere than the one that inhabits the halls of the Federal Reserve system. I believe that the new Governors will work well with them and the professionalism of the whole institution will be upheld.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.