The Fed Is Not An Investment Manager


The Fed Is Not An Investment Manager

Jul 23rd, 2014 3 min read
Norbert J. Michel, Ph.D.

Director, Center for Data Analysis

Norbert Michel studies and writes about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.

“Buy low, sell high.”  It’s a sure-fire prescription for making money on Wall Street…if you can do it.

The problem is that it’s difficult to know when a stock price will bottom out or peak. Also, there’s no objective measure against which you can compare a stock’s price. How high is “too high,” for instance?

Well, fret no more. Apparently, the Federal Reserve has figured out how to solve both problems.  The Wall Street Journal reports:

The Fed says…stock market valuations for small firms, social media and biotechnology firms “appear to be stretched.”

Fed Chair Yellen gave this testimony the same day that Allan Mendelowitz assured everyone at an American Enterprise Institute event that asset values are “fairly easy to understand.”  Mendelowitz went on to say – I’m paraphrasing – it’s easy to prevent asset bubbles, because they appear only when asset values become unhinged from underlying cash flows.

As comforting as these assurances may sound, the truth is that neither Yellen, nor her colleagues on the Federal Open Market Committee, nor Mendelowitz, know anything more about what stock market prices should be than anyone else pretending to know.

Value – even on the stock market – is subjective.  If all buyers and sellers agreed on exactly what the price of a stock should be, we wouldn’t have a market.  Part of the price uncertainty comes from having to value stocks based on expected future cash flows rather than guaranteed future cash flows.

Even if everyone knew exactly what those future cash flows would be, people could still value them differently based on their own beliefs.  Everyone doesn’t value the promise of $100 in the year 2025 the same: just ask a 10-year-old and a centenarian.

When Jim Cramer and pundits on CNBC disagree about what certain stocks should be worth, it’s not a problem.  In fact, it’s good.  But Yellen sits atop the financial regulatory world and, thanks to the Dodd-Frank Act, has powers that go well beyond influencing markets indirectly.

Asset management firms should be particularly worried, as should anyone who invests in stocks and bonds (even through mutual fund companies), because the Fed can now micromanage investments.

The key to this issue is that Yellen now serves a key role on the Financial Stability Oversight Council (FSOC), the committee of regulators most widely known for being in charge of identifying so-called systemically important financial institutions, or SIFIs.  But this council has responsibilities that go far beyond that.

The Fed will be able to force new regulations on financial firms for virtually any stability-related reason the FSOC can come up with.  Securities and Exchange Commissioner Michael Piwowar recently joked that FSOC actually stands for Firing Squad on Capitalism.  It’s not much of a stretch.

Among other harmful policies, the FSOC has clearly expressed its view that asset management firms can pose a systemic risk.  The FSOC’s report is thin on logic, but that’s no barrier to regulators.

Asset managers only invest their clients’ money.  They’re not on the hook for losses.  Putting aside the doubtful proposition that these firms pose systemic risk, the fact remains the FSOC can impose new requirements on these firms to lessen the risks it defines.  And the supposed remedies for this systemic risk are counter to all principles of a private market and personal freedom.

The Federal Reserve, with a compliant two-thirds of the FSOC, can literally break up an asset manager if it deems the firm too risky.  Section 121 of Dodd-Frank gave the Fed the authority to force a firm to transfer assets to an unaffiliated entity, and even to prohibit them from offering products and services altogether.

Want to invest in equities with, for example, Fidelity?  It’s OK for now, but not if the Fed deems the firm to be suddenly “too risky,” or the S&P 500 to have grown too fast.

A few years ago, this scenario would have seemed so far-fetched as to seem ridiculous to all but the most ardent supporters of a government-planned economy.  But not only is it now completely within the realm of possibility, it’s written into the U.S. code.

It used to be that economists simply argued over whether it was a good idea for the Fed to watch asset prices as it monitored inflation.

Now, though, the Fed can do more than simply adjust its monetary policies based on whether it thinks stock prices are too high or too low.  The Fed basically has the authority to act as the world’s active asset manager.

It remains to be seen exactly what the Fed will do with this new authority. Will it impose caps on the number of customers that firms such as Fidelity can accept? Will it direct our largest asset management firms to stop selling small-cap mutual funds?

All of this represents another step toward centralized control of our economy. A recipe for creating wealth and prosperity it is not.  No government agency, not even the Federal Reserve, should be in the business of managing stock prices.  Not for any reason.

 - Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.

Originally appeared in Forbes

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