The following is highly speculative, so don’t take it too seriously.
I was surprised to see stocks rise so strongly today; and even more surprised to see the increase being attributed to the Fed’s QE announcement, which occurred a day earlier. But perhaps stocks were responding to something else. Consider this quotation from a Bernanke piece published just this morning in the Washington Post:
Although low inflation is generally good, inflation that is too low can pose risks to the economy – especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.
Even absent such risks, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating. The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
While they have been used successfully in the United States and elsewhere, purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates. That is one reason the FOMC has been cautious, balancing the costs and benefits before acting. We will review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change.
Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.
Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.
That’s not something Hoenig, Fisher, Plosser or Kocherlakota would have written. It’s pretty clear which side Bernanke’s on. A commenter named Marcus Nunes pointed out that QE is the new fed funds target, at least as long as rates are near zero. Note how Bernanke suggested that there had been a fear of the unknown, which initially caused the Fed to hold back. (Two years ago I told them to come on in, the water’s warm.) But I think he also hints that as they become more familiar with the policy tool, and find out that it doesn’t lead to explosive growth in the monetary aggregates, they are likely to make further adjustments as needed. The new normal. I believe the markets liked that idea. I also think they liked the part about stocks rising in anticipation of the Fed’s decision, and then the additional comment that higher stock prices can help spur the recovery. Where have we heard that it’s not just about interest rates; monetary policy also affects all sorts of asset prices. (Hint: it’s a school of thought that was supposedly discredited when velocity started moving around in the 1980s.)
If I had some literary talent, I’d try a dating analogy for the game that Bernanke and the stock market are playing. Bernanke sends out some sweet talk, the stock market responds with enthusiasm. That emboldens Bernanke (a rather shy guy) to send out a bit more sweet talk, with the confidence his ‘policy tools’ are not viewed as being impotent. I think you can see why I’ll stay away from literature, I couldn’t even write trashy romances.
Paul Krugman seems to think the Fed has a credibility problem; that the markets won’t believe their promises to “inflate.” I’ve argued that there is no reason why Bernanke would not be believed. He’ll probably be in charge for a while, why would he trash his reputation by cheating on the markets once he’d sweet talked them into expecting more inflation. Has there ever been a determined fiat money central bank that tried to inflate, and failed?
The way the stock market responded to rather vague and unimpressive rumors of monetary ease, suggests to me that credibility is the last thing Bernanke needs to worry about. The stock market seems like a lonely girl who laps up anything she hears from a sweet-talking guy with a very big wallet in his back pocket. A cheap date.
What do you guys think? Is Krugman right, or is it easy for the Fed to impress the markets? No need to even mention marriage (i.e. higher inflation targets), just give her a wink and a nod, and promise you’ll spend $600b on the date.
This post has committed two cardinal sins:
- Assuming that if I like Bernanke’s speech, the markets will as well. What do I know about what turns on lonely girls?
- Assuming that it is possible to attribute market movements to specific news, even when we don’t observe an immediate market response in real time.
Still it’s something to think about. Let’s keep a close eye on everything Casanova Ben Bernanke says to the markets in the next few months, and note how they react to the sweet talk.
HT: JimP, Morgan, Marcus Nunes