The chart below is a chart of the US monetary base. In simple terms, it illustrates how much money the Fed has pumped into the financial system. So it’s a kind of visual of what the Federal Reserve is doing. Given the events of the past several years, we can assume when the monetary base explodes higher, the Fed is concerned about stability in the system and therefore pumps liquidity into circulation.
On the chart, you can observe that during the financial crisis the Fed didn't do much until the autumn of 2008 when it pumped nearly $1 trillion into the system - the first vertical spike. In the middle of 2010, the monetary base declined which corresponded to a decline in the stock market. In response, the Federal Reserve injected more liquidity into the system via QE2 at the end of 2010 into the first half of 2011 - the second vertical spike. The stock market followed suit rising sharply in December of 2010 and through the first several months of 2011. The monetary base then declined in the into the fall of 2011 at the same time the stock market declined. Since the beginning of 2012 (the last little spike up on the chart), the Fed has increased liquidity in the system that has, no doubt, been responsible for the stock market's 10% increase so far this year.
What's concerning is that it now takes huge spikes in liquidity to have the desired affect. Any slowdown in liquidity injections seems to negatively impact economic growth, which in turn causes the stock market to decline. At what point will the Fed stop injecting liquidity into the system? Will they ever be able to stop? Nobody really knows.
That being said, as long as the money is flowing freely, we can expect the cash will find its way into the stock market, especially with interest rates at zero. We expect this process can't continue forever, but we can't completely rule out the possibility. Unfortunately, if the Fed continues on this path it will have unforeseen consequences.
