The Federal Reserve’s Reaction to the Next Crisis Might Surprise You

Those who expect the collapse of the current stock market bubble to play out just like the previous two crashes are in for a bit of a surprise.

The normalcy bias is the tendency to assume that future events will continue to unfold as they have in the past. By not accounting for changing conditions, the likelihood of a disaster, and the severity of its consequences, are underestimated.

There is a widespread assumption that the Federal Reserve will respond to the next financial crisis much as it has to previous crises — by loosening monetary conditions, and/or buying up distressed assets. These are the only tools the fed really has, and they will certainly be used at some point, however the scale of the response will not be sufficient.

The Federal Reserve loosens monetary conditions by buying up treasuries (using money created out of thin air). This artificial demand causes interest rates to drop, thereby pushing investors into other assets (stocks and real estate for example) inflating new bubbles. In the past, the fed has typically begun raising interest rates almost immediately after the crisis was contained. However in the aftermath of the the 2007 housing crash interest rates were kept at zero for almost a decade.

This was accomplished through an unprecedented bond buying spree, referred to as “quantitative easing”, during which 4.2 trillion dollars were added to the fed’s balance sheet.

The result was the largest asset bubble in world history, with the S&P 500 gaining 300% following the 2009 recession.

These assets are still on the fed’s balance sheet, and are in the process of being sold off at a rate of 50 billion a month.

This time around the fed doesn’t have the means to inflate a new bubble. They’re out of ammo and moving in the very opposite direction.

As the current bubble collapses there come a moment when the whole world expects the Federal Reserve to step in and take drastic measures. When that expectation doesn’t pan out the we will be in uncharted waters.

By Aaron Hawkins / Creative Commons / StormCloudsGathering