Important Chart

There's a room where the lights won't find you
Holding hands while the walls come tumbling down
When they do, I'll be right behind you
--Tears for Fears

Have been looking for an updated version of this chart for a while. Finally found one courtesy of maven Stephanie Pomboy.

The chart continues to tell an important, if not THE, story behind the huge rise in stock prices (as well as other asset prices) since the 2008 credit crisis.

The graph plots balance sheet assets of the Federal Reserve alongside the S&P 500 Index (SPX) from 2009 thru the end of 2021. The correlation between the two series is unmistakable. Increases in the Fed's balance sheet, which has more than quadrupled in size since 2009, correspond to increases in overall stock prices.

What has caused the Fed's balance sheet to increase so dramatically? The primary driver has become known as 'quantitative easing' (QE)--a program designed to, among other things, stimulate economic activity after major calamities such as the 2008 credit collapse. 

When conducting QE operations, the Fed purchases securities (mostly Treasury and agency bonds) from financial institutions that deal in those securities. For instance, the Fed might observe $100 million in Treasuries sitting in J.P. Morgan's (JPM) inventory, and then buy them all by placing a credit of $100 million with JPM in exchange for the bonds. The $100 million in Treasuries is added to the Fed's balance sheet.

Where does the Fed get the $100 million to buy those bonds from JPM? Out of thin air, baby. It creates the money with a few clicks of a mouse. 

The freshly minted cash now in the hands of financial institutions can be used to fund everyday operations, including trading and speculation in financial securities. As implied by the above graph, a sizable fraction of this cash has gone into stocks over the past decade or so.

It should be noted that the relationship works in reverse as well. When the Fed has halted QE operations over the past decade, stocks generally move sideways along with the value of the Fed's balance sheet assets. And, although you have to squint to see it, on the rare occasion that the Fed has attempted to unwind (read: sell) assets from its balance sheet (which has the effect of removing some of that magically printed money from the financial system), stock prices have fallen.

The only time this relationship did not hold was 2018-2019. Despite Fed efforts to curtail QE and even unwind balance sheet assets during this period, stock prices continued to rise. However, as indicated by Stephanie on the graph, this period also corresponds to a time of tax cuts and deregulation that was favorable for stocks. Stated differently, the bullish backdrop essentially overpowered the bearish forces of Fed actions on stock prices.

The relationship quickly got back on track in early 2020 when the Fed embarked on a gargantuan QE program in response to the onset of COVID-19. The Fed's balance sheet has more than doubled since then to over $8 trillion. The value of the SPX has commensurately doubled as well. 

Moving forward, the relationship between QE and stock prices has important policy implications. As inflationary pressures grow, the Fed may be tempted to curtail or perhaps even reverse its bond-buying practices. Although doing so would relieve inflationary pressures that the Fed itself helped to create, stopping or reversing QE is likely to put downward pressure on stock prices. Any policy that tanks the stock market promises to be politically distasteful.

Whatever the Fed and other central banks who have engaged in QE decide to do from here to address the inflation that they themselves brought about, you can bet that they are looking at the same chart we are...

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