As the stock market continues to push to all-time highs, it is natural to wonder if stocks are in a price bubble. You may hear a lot of people point to the Federal Reserve as the cause of this bubble. Why is that?
The Federal Reserve has the ability to influence interest rates, which is how they try to regulate growth in the economy. Most people, governments and businesses borrow money, so interest rates touch all parts of the economy. When interest rates are low, we can afford to borrow more, which leads to more consumption and economic activity. When rates are high, we can’t borrow as much, so we buy less on credit and the economy slows down.
Since the last recession, the Fed has tried to keep interest rates as low as possible to spur economic growth. The Fed traditionally sets short-term rates for which banks and credit unions can borrow from the central bank. If financial institutions can borrow more cheaply, then they can charge lower interest rates to their borrowers.
The Fed even recently undertook an ambitious attempt to lower long-term rates by purchasing large volumes of long-term bonds, which was referred to as quantitative easing. When the Fed was willing to buy long-term bonds for cheap, it made interest rates for other long-term debt (like home mortgages) lower and more competitive; thereby, decreasing the cost of long-term borrowing in the hopes of making even more credit for big-ticket items cheaper.
Of course, the economy has not improved by leaps and bounds despite the Fed lowering interest rates. I like to use the following proverb to sum up the situation: You can lead a horse to water but you can’t make it drink! By making it cheaper to borrow, that still doesn’t mean people will borrow. The Fed cannot control how people spend money, it can only control how people borrow money (see http://www.mwb-s.com/blog/2014/9/18/monetary-policy-vs-fiscal-policy-why-the-fed-cant-fix-the-economy-alone).
Low interest rates is what investors fear are driving up the stock market. If debt (which includes bonds) have low interest rates, then their yield is unattractive. Worse, if interest rates rise, the value of fixed-interest rate bonds and debt will decrease further. Investors will wait until debt with higher interest rates are issued, and then lend their money. If investors dislike low yield and fear the price of bonds will decrease if interest rates move, then they are going to park their money in the next best thing: stocks!
The belief is investors are biding their time by investing in the stock market until interest rates rise. If inflation were to pick up because of the liquidity from the Fed buying all the long term bonds, then stock prices would go up too. If inflation picks up, interest rates will rise, and the value of existing bonds and debt will get worse. Now it is easy to see why the stock market looks like a pretty attractive place to put your money right now, and if everyone wants to put money there, the value of those stocks will increase because of that.
The real question to consider is what will happen to stock prices when the Fed finally takes action to increase interest rates? The Fed started to slow its last round of quantitative easing starting in June 2013 and finally stopped purchasing long-term bonds in October 2014. The stock market grew throughout that whole time, but people are still concerned what will happen when short-term rates rise.