Is the Federal Reserve Fueling the Greatest Stock Market Bubble in History?

Take a good look at the chart above and you'd be excused for concluding that we're in the midst of the greatest stock market bubble of all time. Not only has the S&P 500 (SNPINDEX: ^GSPC  ) fully recovered from the financial crisis, it's a staggering 30% higher than the peaks of the Internet and housing bull markets.

But is this really the case? With unemployment still above 6%, how could we find ourselves in the throes of yet another brewing catastrophe? Didn't investors and analysts learn anything from the past decade and a half?

While it requires some explanation, the answer is that we're most likely not experiencing another irrational inflation of stock prices. The market's record level is instead a predictable response to the Federal Reserve's policy of keeping interest rates at historically low levels.

Does monetary policy cause bubbles?
As an initial matter, it's important to appreciate that monetary policy itself doesn't cause bubbles. This may sound strange if you've read much about the financial crisis, given that the Fed is often blamed for both inflating and popping the housing bubble. But this narrative is flawed.

The argument goes like this: Following the bursting of the Internet bubble and 9/11, the central bank dropped short-term interest rates to the lowest level since 1958. This drove borrowing costs down and made it easier and more affordable for people to get mortgages and buy homes. Too many people proceeded to do so and a housing bubble ensued.

But the problem with this chain of events is that it excludes a number of critical pieces. Most importantly, it wasn't low interest rates that caused so much havoc; it was the proliferation of subprime mortgages.

At the time, much of the financial industry was operating under two fallacies. First, lenders believed that new derivatives and asset-backed securities had eradicated the risk of default. And second, while it seems absurd in hindsight, many of the best and brightest minds on Wall Street had concluded that housing prices would never stop going up -- or, at the very least, that they wouldn't decline simultaneously across the country.

The result was that these assumptions removed much of the incentive for lenders to monitor credit standards. If there's no fear of default, why not lend to anyone and everyone regardless of their income, assets, or credit score? And it was this behavior, and notably not the Fed's manipulation of interest rates, which fueled the housing bubble and laid the groundwork for the financial crisis.

But what about the stock market's record highs?
This isn't to say that the central bank can't distort asset values by way of monetary policy. Indeed, not only can it do so, but it can do so to a considerable degree.

"Monetary policy has powerful effects on risk taking," Fed Chairwoman Janet Yellen acknowledged in a speech earlier this month. "Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments."

This is exactly what's happened. As Josh Brown recounted earlier this year, "flows into equity funds went megapositive in 2013 while money going into bond funds slowed to a trickle." More specifically, he noted that stock funds have had $298 billion in inflows since the beginning of last year, while bond funds have had only $75 billion.

But that's as far as it goes. In other words, the fact that the Fed's monetary policies have caused stock prices to soar, doesn't mean there's a bubble.

The reason for this is simple. In order for there to be a bubble, asset prices must be more than inflated; they must be irrationally inflated. And, like I've discussed, this isn't the case. If anything, in fact, the increase in asset prices is entirely rational.

As Bloomberg's Noah Smith recently explained (emphasis added):

The value of a financial asset is the discounted present value of its future payoffs, and when the discount rate -- of which the Fed interest rate is a component -- goes down, the true fundamental value of risky assets goes up mechanically and automatically. That's rational price appreciation, not a bubble.

Does this mean stock prices won't at some point deflate? No. In fact, you should probably assume they will. Stock prices correct all the time. But what's important to remember is that a correction isn't a bubble.

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