The Free Market Is Dead: The Fed Killed It.

Adam Smith’s theory regarding the “invisible hand of the free market” has been the backbone of capitalistic societies for decades. It states that market players will arrive at the most efficient and economically viable equilibrium, setting the stage for minimal government intervention. However, the Federal Reserve’s (Fed), increasing intervention in financial markets in recent years has led to a decline in the relevance of Adam Smith’s once widely adopted theory. This shift in economic and financial structure has led to the death of the free market and the establishment of an unsustainable economic system.

The Federal Reserve first introduced quantitative easing (QE) in the midst of the Great Recession and enacted three versions of QE over the next six years, resulting in roughly $3 trillion of cash being introduced into the private sector. Six years after its phasing out, the Fed has once again turned to QE to combat the current economic crisis caused by COVID-19, by creating and reintroducing multiple purchasing and lending facilities resulting in a liquidity injection worth up to $4 trillion. The purchasing facilities provide the Fed with the ability to purchase commercial mortgage-backed securities (MBS), commercial paper, municipal and state notes, corporate bonds in the primary and secondary markets, and bond ETFs. In addition, the Fed’s lending facilities allow it to lend money to banks under the contingency that it be used for the purchase of asset-backed securities (ABS) or to purchase assets from money market funds. The Fed’s lending facilities also allow for it to help fund private sector loans to small and medium-sized businesses. These initiatives have been put in place to provide financial markets, businesses, and governments with liquidity. They have also combined to create inflationary pressures within the credit and stock markets, thereby shifting the financial markets away from a free-market structure towards one that is heavily manipulated and calibrated through government intervention.

The Fed’s initiatives to provide the credit market through liquidity are supposed to utilize the billions of dollars of inflows, funded by the Fed, towards corporate bonds to apply upward pressure on their prices. This is meant to lower corporate bond yields and tighten the corporate bond credit spread. However, the Fed was able to accomplish these goals before it even started contributing any of its allocated capital towards the aforementioned purchases.

Corporate bond prices are linked to corporate profits, stability, and creditworthiness. At a time when many businesses were closed due to COVID-19 and had many issues plaguing their cash flow, corporate creditworthiness took a hit as businesses’ ability to meet interest payments and to survive as a whole came into question. Furthermore, with corporate profits taking a nosedive this year, and the future economic outlook being murky, corporate bond prices faced further weakness. However, by announcing its QE initiatives, the Fed was able to establish an implicit price floor in the secondary market by showcasing their impending participation in the market. It sent a message to investors implying that higher bond prices would be supported by the Fed. Furthermore, the Fed’s primary market bond purchases and further lending practices to businesses also decreased the lending risks associated with corporate bonds. These factors combined to bring investors back to the credit market, increasing demand for corporate bonds across all bond ratings, helping lower yields, and tighten credit spreads.

The Fed’s proposed actions also had drastic impacts on the stock market. Prior to its announcement regarding the reimplementation of QE, capital markets were dysfunctional, with many corporations unable to gain access to credit. This increased near term bankruptcy concerns, as it removed the possibility of adding to available liquidity, which would be used to meet corporations’ working capital and interest payment needs for the short duration of the lockdown. However, the Fed’s proposed initiatives ensured that firms would be able to access the credit markets to facilitate operations throughout the lockdown, alleviating bankruptcy concerns, and increasing shareholder value and demand for stocks. Moreover, by expanding the purchase of corporate bonds to bonds with a junk bond rating, the Fed signalled that it would be willing to take on considerable risk to ensure firm liquidity. These actions helped create a sense of a price floor in the stock market as well, as the Fed indicated its support for corporate America and the lengths to which it would go to help firms maintain liquidity through the lockdown, ensuring that bankruptcy concerns would not be priced into equity prices to a considerable extent. The stock market’s immense uptrend was also attributable to the direct Fed support for corporate bonds on the secondary market. Since the Fed placed upward pressure on bond prices, lowering yields, the return on bond investments was considerably low. This resulted in a lack of alternatives to the stock market when considering investment possibilities, spurring further demand for stocks, and pushing the market higher.

The reaction to the Fed’s proposed details of the reinstatement of QE points to a deeper issue. Investors have come to expect the Fed to flood the economy and the financial markets with immense amounts of liquidity in times of distress. They expect the Fed to backstop the financial markets and to provide struggling firms with a lifeline. These thoughts are not unfounded either. The Fed has essentially created a shell corporation to circumvent the Federal Reserve Act, which prohibits the purchase of corporate assets. Along with pushing past its mandate, the Fed has also taken part in the purchasing of high-risk assets such as junk corporate bonds, exposing it to more risk in order to essentially bailout risk-laden firms. These actions and the investor sentiment surrounding the Fed and its implicit financial market backstop have essentially turned the corporate bond market and the equity market into risk-off investments.

The current ongoing uptrend in the corporate bond market and the stock market has negative implications. Both of these assets’ prices are detached from fundamentals. Bond yields, essentially the cost of borrowing, don’t adequately reflect the companies’ deteriorating creditworthiness nor the firms’ long-term risks, with short-term liquidity reigning king. Furthermore, equity prices are trading close to all-time highs, with discounted future cash flows no longer form the basis of prices. These problems are coupling together to form an asset bubble with tremendous downside risk for investors.

The Fed’s actions have further long-term economic implications as well. The direct purchasing of corporate debt and especially junk bonds further inflates corporate debt, which will make it harder for firms to meet their interest payments and deal with recessions. This will ultimately require more bailouts as firms have less flexibility due to inflated debt levels. These actions will further inflate US debt, while also stoking inflationary pressures due to the excess cash in circulation, which will present itself through inflated prices for goods and services, or through inflated asset prices. Moreover, by purchasing individual bonds, the Fed picks winners and losers by choosing which firms to help and prop up and which it will leave to die. This situation is further complicated since by having a claim to a firm’s resources by being a bondholder, the Fed will also have a potential say in the firm’s operations and decisions. These actions further involve the government in the free market.

The Fed has already taken over the role of the “invisible hand” in the free market by creating implicit price controls and pushing a growth narrative, without letting the market allocate its resources away from companies it may deem too risky. This level of economic planning poses a danger as it opens the door for further centrally planned economic systems to be put in place in the future.

The free market is dead, and the Federal Reserve killed it.