Federal Reserve Led by the Stock Market

David Einhorn was interviewed by Charlie Rose on 6 Dec 2010. See here.

One interesting thing that David pointed out was that the Federal Reserve is inappropriately concerned with the reactions of the stock market. He said he realized it when on the Martin Luther King holiday in 2008, the U.S. markets were closed but the European markets were open.  The European markets fell by a large percentage on Monday, with the U.S. futures market
was indicating that the market would be down a lot.

Without knowing what was the problem, the Federal Reserve called an emergency meeting (via conference call) and lowered the interest rates by 0.75% before the U.S. market opened on Tuesday morning, so the U.S. market never opened at the lower level. The actual press release on 22 Jan 2008 is here, where the Fed announced a 75bp cut to the fed funds rate to 3.5%, and a corresponding 75bp cut to the discount rate to 4%.

It was later revealed in a week that there had been a rogue trader at a large French bank that had taken on some enormous position, and the French bank decided to unwind it by dumping a huge amount of equities on the Monday.

In the FOMC minutes detailing the decision (read here), it noted that

“incoming information… had reinforced the view that the outlook for economic activity was weakening… strains in some financial markets had intensified, as it appeared that investors were becoming increasingly concerned about the economic outlook and the downside risks to activity. Participants discussed the possibility that these developments could lead to an excessive pull-back in credit availability and in investment.”

That truly sounded like they were referring to the stock market drop in Europe. Later in the minutes, it noted

“However, some concern was expressed that an immediate policy action could be misinterpreted as directed at recent declines in stock prices, rather than the broader economic outlook, and one member believed it preferable to delay policy action until the scheduled FOMC meeting on January 29-30.”

Apparently that one member didn’t manage to convince the rest. The official reason given in the press release was “a weakening of the economic outlook and increasing downside risks to growth”, “credit has tightened further for some businesses and households”, and “a deepening of the housing contraction as well as some softening in labor markets”. While these reasons may well be true, the timing of the cut is suspect, especially when it is not a regularly scheduled meeting, so I would tend to agree with David.


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