How the Fed Will Wean America From Cheap Money

June 18, 2013 — -- One of the main reasons for the soaring stock market is the current low cost of capital for public companies. This cost is far lower than it otherwise would be because of a program undertaken by the Federal Reserve Board (the Fed) that goes by the nerdy name, quantitative easing, or, for short, QE.

Essentially, QE (not to be confused with the ocean liner) is the Fed's effort to boost the slow-growing economy by buying about $85 billion in existing bonds from banks every month. It's a form of stimulus, but unlike the earlier rounds of stimulus, the government is lending money with interest attached instead of giving it away or spending it.

Injecting all this money into the economy is keeping many interest rates artificially low. The stock market loves this because lower rates mean more available cash. (Of course, at the same time, the government is committing billions in tax dollars to these loans to stimulate the economy, the sequester cutbacks are reducing stimulus that already existed.)

QE introduces stimulus because its effects on interest rates lower the overall cost of capital, indirectly encouraging more risk-taking and investment in general. All of this helps companies improve earnings, which prompts people to invest.

Whenever anyone on the Fed's board says anything interpreted as less than eternally committed to sustaining QE, the stock market wretches. That's because the market is addicted to this continuous infusion of cash. Other nations in the troubled global economy are doing the same thing. Yet, since such concurrent policy moves by multiple global economic powers is unprecedented, it's hard to say for certain just what will eventually come of it.

Here in the U.S., one thing is clear: The market is so accustomed to stimulus from QE that it is poised to retrench if it is cut off. And it is unduly fearful that the Fed would be short-sighted enough to suddenly turn off the spigot.

The market is such an extreme QE junkie that, perversely, whenever there's talk about the economy improving, stocks go down. Clearly, the market is afraid that the Fed would be cruel enough to put it on cold turkey.

Investors who react this way aren't thinking about a sound economy in which QE wouldn't be needed any more than a heroin addict thinks in terms of life without a fix.

The Fed must decide when and how much to cut back on QE as the economy improves. It faces the challenge of making decisions that have real reactions because of the perverse market psychology – viewing economic recovery is undesirable (at least in the short term) because it would mean less stimulus – that QE policy has created as an unintended consequence.

But the Fed's job isn't to second-guess the financial markets. Instead, its role is to tweak key, controllable aspects of the economy to maintain and improve it as a whole. Part of this involves sending the right signals to the stock market – not by marching to the beat of paranoid investors. Most likely, we will eventually see a Fed treatment plan to wean the economy off stimulus. – a sort of fiscal methadone. This might involve slowly tapering off the bond-buying by reducing it a few less billion each quarter – a move recommended by Alan Greenspan, who was Fed chairman under a few presidents.