Fed Chairman William McChesney Martin once famously framed the Fed’s job as to “take away the punch bowl” before the party got wild. This would prevent the formation of dangerous financial instability before it became a threat. Economists had learned this the hard way after the implosion of the 1920’s stock market bubble led to the Great Depression.
But that lesson has been forgotten. It’s pretty obvious to even the casual observer that Fed now counts among its mandates to keep the stock market up. This policy traces its roots to the so-called “Greenspan Put”, referring to that chairman’s propensity to ease monetary policy in response to market selloffs. Succeeding Fed chairs Bernanke and Yellen quietly continued that policy. The current chairman, Jerome Powell, appeared to resist it after noting that it led to asset bubbles (“financial instability“) whose implosion led to serious macroeconomic stress, notably in the 2008-2009 debacle. This reminder seemed to lead to a relearning of the earlier lesson. After a just under 20% decline in US stock prices in the fourth quarter of 2028, however, the howls of protest from Wall Street and the Oval Office prompted him to cave. The heretofore MIA Powell Put has now been found.
Economist debate whether this focus on stock prices is justified. On one hand, it’s nowhere in the Fed’s official mandate. On the other, it can be argued that stock market declines can lead to economic declines. The problem with this latter argument however is that the ultimate cause of big stock market declines is that prices got too high in the first place. Something can’t deflate without first having been inflated.
Nevertheless, as we’ve argued before, the definition of inflation the Fed uses, being confined to consumer prices, is unjustifiably narrrow, excluding from consideration asset prices. By looking at stock prices, the Fed could simply be taking a step towards rectifying that erroneous view. In which case it could justifiably consider stock prices in pursuit of its price stability mandate.
So we agree that the Fed is justified in opposing large destabilizing moves in asset prices.
The problem is that it’s been a one way street. Tanking stock prices appear to be cause to ease, but runaway moves to the upside don’t trigger restraint. This means that asset bubbles are allowed to form, which in turn are the very conditions that lead to major collapses. This assymetry in policy catches the Fed in a circular tail chase in which it is pursuing policy that creates the very financial instability it says it wants to minimize. If the Fed is to roll consideration of stock prices into its calculus, it has to work both ways. An excellent article at Economics21 gives a little more scholarly treatment of this issue:
The Fed Is Watching the Stock Market – and That Could Mean Trouble
6 thoughts on “The Fed and the Stock Market”
Bernanke came out with a new “idea” or more like a new reason to keep interest rates anchored lower for longer.
In summary the idea is to justify short term higher inflation (than the current arbitrary 2%) following a deflationary period and so averaging out.
You can view his rationalisation here.
Thank for the comment, LL. Bernanke’s rationalization is interesting not so much for what it includes, but what it doesn’t. It doesn’t explain why inflation should be 2%, whether averaged over time or otherwise. A slippery slope theory? It doesn’t explain why only US domestic consumer prices should be considered in calculating the rate of inflation. It also doesn’t present any evidence for the theory that lower interest rates are the best way to increase such inflation, or even make a case that they’re even effective.
Of course this doesn’t mean that these assumptions are flawed, but the fact that such questions are just sort of skipped over, as if just presumed settled, is disturbing in itself. The impact of the policies they’re being used to justify is immense.
I can sure think of other, broader, ways to measure inflation. And causes of deflation at least as plausible as and certainly deeper than the slippery slope theory (that deflation is caused merely by inflation getting too low). And other ways to increase inflation besides lowering interest rates, kiting asset prices, and increasing the wealth gap. But apparently Bernanke doesn’t find anything outside his box worth exploring. Observers could be forgiven for wondering whether Bernanke’s agenda is under the influence of something besides general economic health and monetary stability. He was certainly well placed to put his theories to the test, and the lack of widely shared prosperity only makes me more convinced that the most important questions are often those that aren’t asked.