In search of a nexus between America’s Main Street, Wall Street and the Federal Reserve

During his visit to the United States in 1987, former USSR President Mikhail Gorbachev toured the New York Stock Exchange to observe firsthand the "magic of the market place," a platform for the interplay between the Wall Street and the Main Street. Now, there seems to be a dichotomy between America's economy and the stock market. On Jun 8, the National Bureau of Economic Research determined the US economy entered recession in February due to the coronavirus pandemic. Ironically, the stock market already has recouped over 60 percent of its loss following the March outburst, and had the best quarterly performance in the last two decades. To understand this conundrum, an economic analysis of the past two decades is warranted.

Towards the end of 1990s, the "dotcom" business was booming. New internet-based companies seemed to surface every single week. This tech boom went bust in March 2000, so did the stocks. The US economic growth rate fell from 3 percent in 2000 to 0.2 percent in 2001.

To revive a weak US economy, the Federal Reserve lowered its short-term rate, namely, the federal funds rate, to 1 percent in 2003. Around the same time, after the 1997-1998 Asian Financial Crisis, several countries relied on an export-led strategy to take their economies out of the recession. Their export earnings plus oil revenues of oil-exporting countries including Russia were enabling what former Fed chairman Ben Bernanke popularised in 2005 as a "global savings glut." Those countries were unable to absorb it due to insufficient domestic investment opportunities. The global excess savings finally found its way into the US as a safe haven as well as in search of higher earnings. The Fed's low-interest policy coupled with inflow of funds from overseas helped fuel the housing boom in the US. To check inflationary pressures, the Fed reversed its expansionary policy and raised the federal funds rate to over 3 percent in 2005. The London Inter-Bank Offered Rate (LIBOR) went up too. Home-owners who had the traditional and sub-prime mortgage loans defaulted. The bust in the US housing ensued. This decline also led to the collapse of several financial institutions and money markets. The US economy began to slow down in 2005. The unemployment rate soared to 10.8 percent and the US economy contracted 2.8 percent in 2008, what is also known as the Great Recession. This economic downturn slashed 8.5 million jobs.

As chair of the Fed, Ben Bernanke could easily fully comprehend the depth and severity of the economic downturn because much of his academic work was centred on the 1930s Great Depression.  Under his leadership, the Fed took very aggressive measures to prevent the financial crisis and recession from becoming as devastating as the Great Depression of 1930. In regards to the traditional expansionary monetary policies, the US central bank lowered the federal funds rate from 4.75 percent in September 2007 to 2.25 percent in March 2008, discount rate went down from 5.25 percent to 2.5 percent, and reserve requirements were adjusted from 10 percent to 3 percent during the same time. To bolster the expansion of the money supply, the Fed implemented the Quantitative Easing (QE). During the QE1 phase, the Fed central-bank purchased assets such as government bonds and other securities, direct lending programs, and programs designed to improve credit conditions. In November 2010, the QE2 was launched. It consisted of a further purchase of $600 billion in US Treasuries, and reinvestment of proceeds from prior mortgage-backed security purchases. The QE3 was announced in September 2012 for the Fed to buy $40 billion in mortgage-based securities from member Federal Reserve banks.

On the other hand, the US administration too undertook expansionary fiscal measures. The US budget deficit jumped from $160.7 billion in 2007 to $458.6 billion in 2008, which skyrocketed to $1,412.7 billion by 2009.

Due to a well-coordinated strategy and with a combination of loose monetary and fiscal policies, the US economy recovered from the 2008 recession to post a 0.2 percent growth rate in 2009 and 2.6 percent in 2010, faster and better than almost every advanced country. Total employment rose by 17.9 million from March 2010 through December 2017.

There has certainly been a fiscal cost to these rosy employment numbers and economic growth rates. The US gross debt rose from $13.6 trillion in September 2010 to $22.7 trillion in September 2019.

How are lawmakers and policy officials interpreting the monetary and fiscal policies for now and future in light of these economic conditions? In terms of unleashing expansionary monetary policies, the Fed has determined its easy money has hardly pushed the inflation rate above its 2 percent targeted range. The lawmakers have been convinced that, i) the so-called "crowding-out" theory and ii) higher budget deficits & debt will cause interest rates to go up, which have been discredited empirically in the US in recent decades. Given the total federal debt estimated to be $29 trillion by September 2020, the 10-year Treasury yield fell to a historical record low of 0.66 percent last March.

This year, the unemployment rate unexpectedly skyrocketed to 16.4 percent in April from 3.8 percent in February. The US has already lost 47 million jobs since the coronavirus pandemic began, erasing all job gains in recent years. The government data show the US economy contracted 5 percent in the first quarter of 2020.

A lawyer by training, Fed Chairman Jerome Powell was very prompt in taking a page from his predecessor Ben Bernanke's playbook. During a virtual conference on Jun 10, Powell said, "We are strongly committed to using our tools to do whatever we can and for as long as it takes to provide some relief and stability."

On the fiscal side, Congress has doled out $3 trillion in stimulus funds.

In sum, the Fed's zero-interest policy is fuelling the stock market, while Congress' stimulus money is propping up the American economy. Apparently, America's Wall Street and the Main Street have parted ways for now.