Household Portfolio's Show the Uneven and Unfair Effects of the Modern Monetary Policy Regime
Updated: Sep 27, 2020
For more than two decades, policymakers have followed the rationale that maintaining a low and steady inflation rate produces the best macroeconomic outcomes. I challenge the Federal Reserve to offer a shred of neutral evidence of how this policy approach has improved the performance of the economy. Growth cycles have not been stronger, and recessions have not been shallower. But there is evidence of how the policy of maintaining low official rates to hit an inflation target has resulted in uneven and unfair outcomes in finance.
According to the Federal Reserve's Financial Accounts of the US, the market value of equities directly owned by households stood at $21.3 trillion at the end of 2019. That was an increase of roughly $14 trillion in the past 20 years.
Households held an identical amount, $21.3 trillion in interest-bearing accounts such as time and saving deposits and direct ownership of debt securities. Also, in the past 20 years, the market value of these accounts has increased $15 trillion, or $1 trillion more than equity holdings.
At first glance, it appears that equity investors and yield (or income-seeking) investors have experienced equal outcomes. But that’s not true.
In the past 20 years, households have withdrawn (“Tapped the Till”) more than $11 trillion from their equity holdings. In contrast, 85% of the increase in the market value of the yield-related investments stemmed from new flows (i.e., people adding more money to their time and saving accounts or purchasing more debt securities). Uneven and unfair outcomes!
During the 20 year period, the broad equity market experienced two declines that cut the market value of equities in half. But despite those two protracted and sharp declines people's equity portfolios far outperformed those that were invested in interest-yielding or fixed-income assets.
Randy Forsyth of Barron's has written about a new investment thesis ("TINA", there is no alternative---to equities) in portfolio management. It is hard to argue against this portfolio advice since policymakers are promising low-interest rates for an extended period, and by doing so are encouraging people to take on extra risk.
Federal Reserve policy has upended traditional portfolio management. Diversification is no longer needed. It also creates a disincentive to save as enormous wealth in the equities has been driven by price appreciation. No need to save when the Fed promise of low interest rates forever keep increasing the market value of equity.
Equity investors have been on the right (or lucky) side of the "uneven and unfair" outcomes of modern monetary policy. But the advantage of continuing winning only works as long as the house (the Fed) continues to offer cheaper and cheaper money. With official rates at zero, the formula to discount future corporate earnings has maxed out. The famous economist Herbert Stein said, "If something cannot go on forever, it will stop."