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For all their estimable attributes, central bankers generally are not endowed with an appreciation of irony. Not the least example is their belief that by manipulating variables such as interest rates they can produce an economy without booms or busts, unemployment or inflation.
They had thought they attained a sort of nirvana dubbed The Great Moderation to describe the decade of the 1990s and much of the early 2000s, in which steady growth was interrupted by only mild recessions and not disrupted by rising inflation. That is, until the crisis of 2008, which precipitated the worst economic contraction since the Great Depression.
Undeterred by that experience, the Federal Reserve has exerted its full force to counter that contraction. The first phase of liquidity provision through over $1 trillion in bond purchases — QE, or quantitative easing as it's called in polite company — helped to offset the contraction of liquidity resulting from the crisis; that is the traditional role of central banks, to provide money when everybody is hoarding it.
The second phase, QE2, came in late 2010, when the Fed decided to purchase an additional $600 billion in Treasury securities. What was different this time is that Fed chairman Ben Bernanke explicitly said QE2 aimed to boost the stock market as an avenue of stimulating the economy in an op-ed article in the Washington Post.
After extolling the benefits of lower long-term interest rates on corporate bonds and home mortgages, Bernanke added: "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."
The boost to wealth and consumer confidence has accrued almost exclusively to the 52% of Americans who own stocks, based on a Gallup survey. It has not flowed through to jobs as the employment-to-population ratio has remained at 58.6% of the working-age population, within tenths of a percent of the recession low.
In the minutes of the December Federal Open Market Committee meeting released Wednesday, some members of the policy-setting panel expressed concern that QE3 — which it decided to trim back by $10 billion a month, to $75 billion, starting this month — was beginning to inflate asset prices.
"In their discussion of potential risks, several participants commented on the rise in forward price-to-earnings ratios for some small-cap stocks, the increased level of equity repurchases, or the rise in margin credit. One pointed to the increase in issuance of leveraged loans this year and the apparent decline in the average quality of such loans. A couple of participants offered views on the role of financial stability in monetary policy decision-making more broadly. One proposed that the Committee analyze more explicitly the potential consequences of specific risks to the financial system for its dual-mandate objectives and take account of the possible effects of monetary policy on such risks in its assessment of appropriate policy. Another suggested that the importance of financial stability considerations in the Committee's deliberations would likely increase over time as progress is made toward the Committee's objectives, and that such considerations should be incorporated into forward guidance for the federal funds rate and asset purchases."
In other words, the FOMC has begun to take into account the distorting effects on financial markets of their actions. The irony is, as Bernanke indicated back in 2010, that was the monetary authorities' intent.
Now, with stock prices up 30% from a year ago and home prices escalating at double-digit rates, Fed officials are expressing second thoughts about the market-distorting side-effects of their policies. Fed Governor Jeremy Stein has made the point most particularly that the Fed's policies have induced investors to reach for higher returns while the Fed has pushed down Treasury yields, with potentially destabilizing effects.
It's not clear from the FOMC minutes how many of the panel's members worry the Fed is blowing bubbles. But it is evident the Fed's bond purchases have been more successful in boosting asset prices than jobs.
That said, it also isn't clear that the Fed will alter its presumed policy course of gradual reductions in its bond purchases, most likely with cuts of $10 billion per month announced at each FOMC meeting, while emphasizing its "forward guidance" that short-term interest rates will be kept near zero until well into next year.
The FOMC even called the steps it plans as "measured," the same modifier it used in the middle of the last decade to describe its glacial rate of interest-rate hikes of a quarter-percentage point per meeting. That gradual lift-off in rates from ultra-low levels provided plenty of leeway to inflate the housing bubble.
Will the Fed recognize its actions feed into inflation of asset prices more than employment and wages? The latter are the expressed concerns of the incoming central-bank chief, Janet Yellen. Most likely, the Fed won't be deterred from its present course, and won't appreciate the irony that it risks inflating an asset bubble yet again.
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