Given the recent massive run-up in U.S. equities and the massive run-down in the U.S. dollar, I wanted to get out three thoughts on one of the key drivers of this move.
As a refresher, here are the key phrases:
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.
The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens….. and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
Thought #1: Bernanke isn’t targeting interest rates, but is targeting the stock market.
This is an attempt to drive the value higher to create what is called the “wealth effect” or WE increase consumers and businesses propensity to invest and spend as they see the value of their stock holdings rise. Remember, this was the goal of QE2 with somewhat mixed results as equities went up, but spending didn’t accelerate at the pace the FOMC wanted.
The problem with this strategy is that “income effects” or IE of rising inflation can wipe out wealth effects.
After the Bernanke Jackson Hole speechand follow through from the FOMC, US inflation expectations rose slightly, commodity prices rose strongly, and US 10 year Treasury yieldsrose dramatically. Remember, the goal of the Fed is to drive investors away from perceived Risk-free assets like US Treasury securities into perceived Risky assets like equities and high yield bonds.
The argument for the additional easing by the central bank is predicated upon two ideas.
One, the U.S. economy has considerable slack on both the employment and production side. Two, the central bank will act with alacrity on inflation. While I concur on #1, I disagree on #2. What makes me especially circumspect is the line: “the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” This follows the belief that if inflation is below their target level of 2%, they should allow inflation to go above the target level to offset it. Clearly, the markets are not waiting for inflation to show up before they show their concern. The promise by the ECB to buy bonds is further driving this concern for the inherent risk for the FOMC’s policy directive.
Bonus Problem: the political risk of this policy is extremely high. First, this policy makes a distinct choice to benefit investors over those that will suffer from a rise of inflation. Second, the Obama administration will be perceived as benefiting from actions taken with close proximity to the US general election in November.
Thought #2: The FOMC will not be concerned over a weaker US dollar.
As mentioned above, the US central bank has not only promised QE, but will deliver on it starting this month. This is different from the ECB saying they will engage in OMT if sovereigns agree to an IMF directed austerity plan. This means the US is acting to electronically create US dollars in US bank accounts and thereby attempting to inflate the system with more money.
The response has been dramatic.
The initial response to the ECB is similar to my own reaction to being in the passenger seat with my student driver son and about to get on a highway for the first time…..and then getting off the highway alive. A palpable sense of relief from avoiding death is what investors have felt in Europe due to the promise and plan of Draghi. The EUR rallied , bond yields have fallen dramatically for Spain and Italy, and stock markets in Europe have rallied. All of this has happened without a single shot being fired on the OMT or QE side by the ECB.
This is the cheapest intervention I can think of in modern finance. It stands in stark contrast to the US where Bernanke & Co. have not only announced, but will start acting this month on QE. The benefit for the US will be a weaker currency that increases the competitive position of the country’s exporters. Given the FOMC’s belief that inflation is not an issue, the central bank should theoretically tolerate a further devaluation between 5-10% in addition to what has already occurred before they wake up and take notice.
Thought #3: The Bernanke legacy will resemble the Greenspan legacy.
The early part of the Greenspan regime was marked by the 1987 stock market crash and response. The adulation was strong. The middle part was marked by the deft navigation of “irrational expectations” and the continued pumping of money into the system to aid the economy for a potential “Y2K” event.
The latter part was marked by an easy monetary and regulatory policy that helped fuel housing prices higher until they collapsed. It’s difficult to look at a picture of Greenspan now and think “Maestro.”
The early part of the Bernanke led Fed was marked by the “Great Recession” and the amazing policy coordination with the US Treasury and Congress. The middle part is being currently marked by the numerous extensions of QE intervention by the central bank in an attempt to fuel job growth that has presently been underwhelming in its delivery. The latter part of the Bernanke regime is yet to be written, but the groundwork is being laid now.
History is full of examples of central banks waiting to act until the right moment to act, then acting too aggressively, and then having to act again to offset what they just acted upon. Quite simply, it is human nature to continue to attempt to change the outcome of the future with further action simply because you can act. It takes true wisdom and leadership to know when the reward is not worth the risk.
We’ll see where history judges Bernanke’s decision to continue to act.
Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.