“Is the Fed being an enabler for an addiction that Congress can’t overcome?”
This was a question posed to Federal Reserve Chairman Ben Bernanke by Senator Dan Coats (R-IN) during a hearing on the U.S. economic outlook on May 22. To say the least, the question is loaded. Critics of the Fed’s easy-money policy suggest that stock prices are inflated and the markets are overheated. Ostensibly, evidence of this is in plain sight: the S&P 500 has experienced a tremendous rally in the wake of the financial crisis.
The rally has been born on the back of quantitative easing — one of the Fed’s unconventional monetary policy tools, through which it is purchases $85 billion per month on bonds and mortgage-backed securities. These purchases have four primary effects on the economy: higher inflation expectations, currency depreciation, higher equity valuations, and lower real interest rates. QE is similar to normal monetary policy in that it puts downward pressure on nominal and real interest rates.
At the end of the day, QE has an obvious affect on the markets:
“Is this creating another potential bubble?” asked Senator Roads, capturing the concerns of many. “There’s a big surge in the markets here that seems to be not enforced by underlying fundamentals.”
This question and this concern has been forefront in the minds of investors for months, if not years. The insane post-crisis rally comes packaged with the reasonable fear that some sort of crash must be coming soon. Historically, the market has only increased at such a pace immediately before a crash.
But many economists, including Bernanke himself, are not actually that worried that a crash is coming. At least, based on historical price-to-earnings data, there doesn’t seem to be any reason to panic. In order to try to predict an impending crash in stock prices, a better indicator than just the price of the S&P 500 is the price-to-earnings ratio of the index. Using this measure, it’s clear that current market prices are supported by strong earnings, and the ratio is within a historically normal range.
How long will the Fed keep its foot on the gas?
If the Fed’s easy-money policy is supporting higher stock prices, it is also supporting corporate earnings. In the short run, this is a perfectly viable strategy to stimulate a sluggish economy. However, Bernanke has made it clear that ensuring the long-term growth of the U.S. economy is the job of fiscal policy, and for that the buck stops with Congress. The Fed can only keep its foot on the gas for so long.
In January, the Fed adopted an additional unconventional policy and explicitly set a 2.5 percent inflation threshold and 6.5 percent unemployment target as the minimum criteria for a policy rate move. As it stands, remaining within the inflationary speed limit has been a cake walk. If anything, as Bernanke has pointed out, inflation is too low.
Unemployment, on the other hand, is an entirely different matter. Employment has been slow to recover, and improving the health of the long-term labor market is largely out of the Fed’s control.
“My worry is that the Fed doesn’t have the prescription for what ails our economy,” said Chairman of the Joint Economic Committee Congressman Kevin Brady (R-TX). “A year ago, the Fed said that it wouldn’t set an employment target rate because it’s generally affected by non-monetary factors. But you’re unwinding the QE based on the employment areas that you have the least control of. What do we make of that?”
After addressing a leading statement about the slowness of the recovery (in which Bernanke cited fiscal policy as a significant headwind to growth, and defended aggressive monetary policy), Bernanke confirmed that monetary policy alone can not directly influence the level of long-run unemployment.
“What we are trying to address here is the short-run cyclical gap,” he said. “We are seeing the economy operating at a level below what it is capable of operating at, and many people out of work who normally would have work, and monetary policy can help to put people back to work in the short run.”
Again, the major concern is that the markets have become addicted to this short-term stimulus and that long-term economic conditions have no improved enough to taper QE. “You cautioned in your statement that too much restraint too quickly continues to be the headwind that we may not want to get in to,” commented Senator Road. That is, if the Fed stops feeding the market addiction, the withdrawal could prove devastating.
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