Michael Shulman

Will the Fed Bring Down the Market?

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The Fed is currently having a moral crisis over pulling back credit support that is being mistaken for an identity crisis. Let me explain.

The Federal Reserve was established to manage the nation's money supply and banks. The baking system uses the Fed's balance sheet and discount window, while the Fed provides regulation. As bankers gamed the system (that's not a criticism, that is their job), some of these regulations changed and became stricter over time.

In 1978, the Humphrey-Hawkins Full Employment Act gave the U.S. government the goal of providing full employment. It also said that the Fed chairman must give testimony to Congress reporting on the state of the economy.  

With the Fed mandated to enter the policy arena, it meant the Fed would no longer just have to worry about the longer-term problem of inflation, but a short-term problem, the current economy, as well. The Fed was given this responsibility because the same tools -- money supply and interest rates -- could be used in different ways to manage both inflation and economic issues.

Fast forward to the subprime mess, CDOs, Bear Stearns and Lehman Brothers -- and boom! The Fed jumped in with both feet to make sure the financial sector and then the economic world did not completely spin off their axes.

And now the Fed is taking steps to remove one foot and then another, and returning to its past role as guardian of the money and inflation, and occasionally unemployment.

And that is the conundrum facing Wall Street right now: Is the Fed stepping back a good thing or a bad thing for stocks?

What's This Mean for the Market?

First, stepping back means ceasing purchases of Treasury bills and ending other programs to inject liquidity into the market. The Fed is still buying boatloads of conforming mortgages, which are guaranteed by Fannie and Freddie (i.e., you and me), but they are starting to pull back.

Second, Uncle Sam, in the form of the FDIC, is also withdrawing guarantees of bank debt.