Can The Fed Really Cause A Stock Crash As Trump Claims?

President Donald Trump has zeroed in on the Federal Reserve’s interest rate increases as the main reason for yesterday’s nosedive in stock prices.

“It’s a correction that I think is caused by the Fed and interest rates,” Trump told reporters. “The dollar is very strong, very powerful and it causes difficulty in doing business.” During a telephone conversation with Fox News later, the President said the Fed was “going loco” and that he was not happy about it. According to Trump, the Fed's interest rate increases this year have been “far too fast, far too rigid”. 

The Fed controls the levers of the U.S. economy by making policy, so it makes sense that traders would be fearful when the President criticizes the central bank. But history and precedent tell us that the Fed’s ability to cause a sudden stock market crash may actually be limited.

Can Fed Policy Cause Sudden Stock Market Crashes? 

The Federal Reserve’s policymaking has an indirect effect on markets and the economy. An increase in interest rates makes debt more expensive, while a corresponding decrease can make it cheaper. But the effects of changes in interest rates are not immediate and take time to ripple through the broader economy.

For example, some experts say that the roots of the 2008 financial crisis date back to 2000, when the federal agency began slashing interest rates. Low interest rates fueled a housing boom until 2005, when the agency began a policy of rate increases to temper growth in an overheated economy. (See also: The 2007-2008 Financial Crisis In Review). 

You would expect that damping down economic growth would draw a negative reaction from U.S. markets because it signals an impending economic contraction. But markets at the time reacted positively to the rate increases and continued to push upwards, reaching even higher valuations as the agency doubled down on rate increases. When the markets did finally crash in 2008, the catalyst was not a further decline in Fed rates but the fall of investment bank Bear Stearns. (See also: Dissecting The Bear Stearns Hedge Fund Collapse).      

What Happened Yesterday? 

On the back of historically-low unemployment rates, a humming economy, and a record bull market, the Fed has already hiked interest rates three times this year. Coupled with those hikes is an aggressive stance indicating that the federal agency might not be averse to further rate increases in the future. 

During a PBS interview last week, Fed Chair Jerome Powell said accommodative interest rates, or low rates to encourage economic growth, were no longer needed. “Interest rates are still accommodative but we are gradually moving to a place where they will be neutral,” he said, adding that the US economy was a “long way from neutral (interest rates) at this point, probably.”

A neutral rate enables economic growth without the risk of significant inflation. The rate is an estimate and its calculation depends on a host of factors, including inflation and the state of the global economy. The Fed's current rate is 2.25 percent and commentators expect the agency to increase it to 3.4 percent. 

Experts from JP Morgan Chase International have publicly backed the Fed’s moves. “The Fed has not gone crazy. The Fed policy of normalization is exactly the appropriate one,” said Chair Jacob Frenkel.

Steven Mnuchin, Treasury secretary, echoed that sentiment, referring to yesterday's stock market crash as a “correction”. “The fundamentals of the U.S. economy continue to be strong," he said. "I think that’s the reason the stock market continues to perform well…The fact that there’s a market correction is not particularly surprising."