The Fed Can't Ignore Its Role in GameStop Saga

I have very specific memories of the dot-com bubble. Working as a clerk on the Pacific Options Exchange in San Francisco some two decades ago, I can recall normal yellow taxicabs that suddenly became Yahoo! taxicabs. They were painted purple and provided internet access for passengers. It seemed like every billboard was for some startup internet company. A reporter from the San Francisco Chronicle found his way to the trading floor one wild day and got one of the traders on the record saying, “I can’t believe how much money I’m making!” Nothing captured the zeitgeist of the moment better.

It may be a cliché, but it’s generally true that the more things change, the more they stay the same. Today, again, it seems like everyone is getting rich, whether it be in Special Purpose Acquisition Vehicles (SPACs), whatever Chamath Palihapitiya is touting, the latest stock-of-the-day in Reddit’s WallStreetBets forum, or digital currencies. And similar to 2000, there is a group of people now who are questioning the mania, deciding to stay invested in stocks with actual revenues and earnings instead of those built on hopes and prayers.

The current mania is different for one key reason: monetary policy. Back then, the Federal Reserve had raised interest rates to 6.5% heading into the new millennium. I had most of my money sitting in a money-market account, not seeing a great deal of incentive to risk it in the stock market. Much higher interest rates made the certainty equivalent of cash more attractive than it is today with the easiest monetary policy imaginable and negative real rates, which is probably the chief source of all this speculation. Real, after inflation, interest rates that are positive have a tendency to refocus people’s attitudes towards risk. If you’re getting a significant positive return in a risk-free instrument, then why take risk in stocks?

People don’t have the luxury of that option today. The Fed has two mandates: price stability and full employment. It is spending much more time thinking about full employment these days with more than 10 million Americans out of a job due to a pandemic and inflation rates being low and stable. As a result, interest rates are pinned near zero, and are actually negative after taking account even moderate levels of inflation. It’s also pumping $120 billion directly into the financial markets each month, and sees no reason to slow the pace to ensure the recovery from the worst downturn since the Great Depression doesn’t digress.

With so much easy money sloshing around the economy and financial markets, and money- market accounts paying less than zero after inflation, it’s no wonder that many indicators show that investor sentiment is at beyond euphoric levels. The market strategists at JPMorgan Chase & Co. wrote in a recent report that “households’ equity allocation has risen to record highs, surpassing its previous high seen at the beginning of 2000 at the peak of the dotcom bubble.”

It’s hard to miss the tell-tale signs of a bubble. Initial public offerings are popping more on the first day of trading than they have since the dot-com days, as evidenced by the recent performance of companies such as Airbnb Inc., DoorDash Inc. and Snowflake Inc. Then there’s the recent raid by speculative day traders on GameStop Corp. and other companies with outsized short interest in their shares. Not to mention the bankrupt car rental company Hertz Global Holdings Inc. and other low-priced stocks that experienced a buying frenzy a few months ago for no fundamental reason. The Robinhood trading app is turning investing into something akin to a video game. And let’s not forget the digital currencies led by Bitcoin.

If it acts like a bubble, it probably is, which is why, just like 20 years ago, there’s a raging debate about whether it is the Fed’s job to tamp down excessive speculation when it occurs so that a bigger bubble doesn’t burst further down the road, causing severe economic damage. The topic was certainly on then-Fed Chairman Alan Greenspan’s mind when he gave his unforgettable “irrational exuberance” speech in December of 1996. Of course, it took a while for Greenspan to do anything about it, and the stock market rose for three more years. And the bursting of the dot-com bubble did result in an economic recession and a nasty bear market that saw the Nasdaq 100 Index falling more than 78% between March of 2000 and October of 2002.

The troubling part is that I don’t get the impression that conversations about excess speculation are being had inside the Fed. Chair Jerome Powell dodged the question last week during his post-Federal Open Market Committee press conference, only saying that there’s not a strong link between interest rates and asset prices. But we can clearly trace the origins of the 2008 financial crisis to monetary policy after the dot-com bubble, when rates were slashed to below 2% and held there for more than three years. We’ve had three large, speculative manias in the last 21 years, and they were all a result of prolonged period of time with negative real rates.

Former Fed Chairman William McChesney Martin once said that it was the Fed’s job to take away the punch bowl just as the party was heating up. Admittedly, he was referring to the economy heating up, not the financial markets, but the divergence between the real economy and financial markets is currently so extreme that it can’t be ignored. The Fed’s current interventions were meant for times of crisis, and the financial markets are no longer in crisis. They should be gradually withdrawn, starting with the Fed’s purchases of exchange-traded funds and corporate bonds. The Fed must realize that the markets are in the midst of a raging party, and the first beer bottle just got thrown against the wall.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of "Street Freak" and "All the Evil of This World." He may have a stake in the areas he writes about.

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