“When will these guys ever learn that maybe, just maybe, these Fed policies aimed at targeting asset prices at levels above their intrinsic values is probably not in the best interests of the nation?”

-Dave Rosenberg, chief economist and strategist at Gluskin, Sheff


Not long ago, I was listening to former Federal Reserve Chairman Ben Bernanke discuss the central bank’s actions during and after the financial crisis. I came away very impressed with how thoughtful and intelligent the former head of Princeton’s economics department was. Combining a deep academic background in the Great Depression with outside-the-box thinking made him the perfect person to lead the Fed during this period.

There was one issue in particular that bothered me about his tenure, and it isn’t a minor one. It is the Federal Open Market Committee’s focus on the so-called wealth effect, and its corollary impact, the stock’s reaction to Fed policy.

Let’s begin with a quick definition: The wealth effect is an economic theory that posits rising asset prices leads to beneficial effects in consumer sentiment, retail spending, along with corporate capital expenditure and hiring. It is based on a belief in a virtuous cycle that begins with equity prices. As they rise, investors and senior corporate managers begin to feel more secure and comfortable in their financial circumstances. This improvement in psychology releases the “animal spirits,” along with a commensurate increase in spending. Pretty soon thereafter, the entire economy is moving on the right direction.

But Fed policy makers seem to have gotten this precisely backward. Their premise is based upon a flawed statistical error, one that confuses correlation with causation. Building an entire thesis upon a flaw is likely to lead to poor results.

Why is the wealth effect a flawed theory?

Start with that correlation error: What actually occurs during periods where stock prices are rising? As Benjamin Graham observed, over the long term, markets act like a weighing machine — valuing equities based on their cash flow and earnings. During periods of economic expansions, it is the rising fundamental economic activity that reflects the positive things wrongly attributed to the wealth effect. Companies can hire more and increase their capital spending. Competition for labor leads to rising wages. Employed, well-paid workers spend those wages on capital goods such as cars and houses, and discretionary items like entertainment and travel.

Oh, and along with all of these economic positives, the stock market is buoyed as well, by increasing profits and more buoyant psychology.

In other words, all of the same forces that drive a healthy economy, leading to happy consumers spending their plump paychecks, also drive equity markets higher. The Fed, though, seems to think that the stock-market tail is wagging the fundamental economic dog.

As we saw in the mid-2000s, it wasn’t the wealth effect driven by rising home prices that led to greater economic activity, but rather access to cheap and widely available credit.

The flaw in this thesis is even more obvious when we consider the distribution of equity ownership in the U.S. The vast majority of employees and consumers have only modest investments in equities. When we look at 401(k)s, IRAs and other investment accounts, we see these are primarily held by the well-off. Ownership of equities is heavily concentrated in the hands of the wealthiest Americans. Start with the top 1 percent: They own about 40 percent of stocks (by value) in the U.S. The next 19 percent owns about 50 percent. That leaves the remaining four-fifths of American families holding less than a 10 percent stake in the stock market.

With so few people actually invested in the results of the stock market, how can it have such a broad effect on consumer spending? It doesn’t, unless the Fed wants to make the case that it is driven primarily by the trickle-down effect. I doubt they would want to do so for obvious political reasons.

Which leads to a Fed policy that has become overly concerned with the markets reaction to well, everything. Fed policy, FOMC member speeches, even FOMC minutes are obsessively considered in light of how markets will react to them. This is a terrible and unique Fed error. It makes for bad policy and worse governance in a democracy.

Some might perceive the wealth effect and the focus on market reactions to be two distinct issues. In reality, they are so closely intertwined that they are effectively two sides of the same coin.

The Fed must put to rest this flawed approach, and along with it a wealth of poor policy decisions.

Originally published here

Category: Federal Reserve, Philosophy, Really, really bad calls, UnGuru

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

18 Responses to “Fed is Too Focused on Wealth Effect, Equity Markets”

  1. Concerned Neighbour says:

    As I’ve said many times, QE should have ended after the first necessary though unpalatable dose. Future QE’s have:

    - predominantly benefited those most responsible for the crisis
    - significantly increased wealth inequality
    - made a mockery of “free markets” by destroying the price mechanism and as a corollary lead to tremendous mis-allocation of capital
    - lead to share buybacks instead of real investment in the future of the economy
    - decreased confidence in the economy and the markets because people recognize the manipulation for what it is and don’t understand why so-called “emergency” measures are needed in perpetuity and feel the deck is permanently stacked against them
    - hurt conservative investors who are either unwilling or unable to speculate in bubble markets, leaving no alternative

    I liken QE to trickle down fiscal policy, another policy that doesn’t work. No matter, of course. As we can see by today’s action, BTFD (and/or the Japan carry trade) are still fully intact.

  2. Francois says:

    Excellent observations Barry!

    Alas, the Fed will not abandon this approach for obvious political reasons. The 0.01% owns and they shall not tolerate their pet wishes being neglected.

  3. TDHawk says:

    What is the animal spirit? I don’t see a definition there.

    Mr. Bernanke seems to be generally closed minded in his interviews. I have yet to see an intelligent discussion with vision or practicality. Maybe that could too be attributed to bad calls?

    Sure he went to school and bureaucratically smart, but he doesn’t know how to think critically. Just look at that picture?! For someone who accepts all these economic theories and with so much doubt.

  4. holulu says:

    Two points.
    1) “wealth effect” is fiction just like “trickle down economy”.
    2) Yellen just after her nomination said “….housing is on track…”. That statement confirmed that she either has sh!!t for brain or has NO intellectual integrity, knowing that she is smart person then the 2nd is probably true. In old days people used to earn good income and then buy a house, but now people do not need income they just have to own real estate to get wealth. Cart is in front of the horse.

  5. VennData says:

    What else can they do when the GOP is willing to shut down government if you try to build roads, repair bridges, etc?

    I’m sick of people blaming “Washington” when the GOP is the problem.

    • VennData says:

      And the “…animal spirits…” are counteracted by the Looney Fox News “Obama is running America” nonsense.

  6. Easyenough says:

    I thought the former chairman said at more than one press conference that the poorly named “wealth affect” was primarily intended to occur through home price increases? Because it’s the most widely held asset and because new home construction is one of the single biggest contributors to the rest of us (the 80%) having jobs and incomes. Rising stock prices (and 401 ks) are just a secondary, and politically unfortunate, consequence.

  7. b_thunder says:

    “The Fed, though, seems to think that the stock-market tail is wagging the fundamental economic dog.” – that’s EXACTLY what the Fed is doing. And I’m sure they understand that the economic “bang for the buck” that they’re getting from the wealth effect is very low. But they do it because this is all they’ve got left. This is their final tool.

    And while some call it “wealth effect,” I prefer the term “confidence” (or CON-fidence) that in Fed’s view the rising equity prices give to consumers to spend and the managers to raise CapEx.

    They’re willing to take (imho) absurd, crazy, hardly comprehendable amount of risk to preserve the system built over the last 30+ years on financialization and releveraging. The reset of such system will make everyone “poorer” and will make many wealthy individuals and seemingly solvent institutions insolvent and bankrupt thanks to the magic of leverage.

    So the Fed is working to prevent us from shouting “The Emperor has no clothes!” by making sure that everybody benefits (even marginally) by keeping quiet. But eventually the Ben Graham’s “weighing machine” is bound to swing in the opposite direction and then the confidence in Fed will disappear and there will be a stampede to sell similar to the one from the “Trading Places” but on a much grander scale, where Yellen, Draghi and Kuroda will play the part of the Dukes.

  8. DeDude says:

    The economy is almost always restricted by demand. Any policy that can increase demand will have a positive effect via that mechanism, but it may also have (short- or long-term) negative effects that need to be carefully evaluated. When there is a large excess capacity and huge amounts of excess investment capital slushing around, then the only way the “wealth effect” can have positive influence on economic growth is by getting consumers to spend. But the consumer class is characteristically not a group of people who have much of any assets beyond their homes. So the only “wealth effect” that in theory can do much for todays economy is to help increase the value of homes. However, that can also be overdone since a lot of consumer class individuals purchase their homes on 30-year mortgages and the more their monthly payment is the less they have left for consuming.

  9. carleric says:

    I am always amused by the people who think the Fed has a clue on how “average” people think and act. The truth is the Fed only cares about the banks and the very rich. Supporting the stock market with the goal of helping the economic recovery would be laughable even it weren’t so pathetically stupid. Bennie is not and was not the savior of the world….get over the hero worship

  10. Robert M says:

    You have done a really good job making it clear your job is to make money for your clients first and the blog thoughts second. Do you conversations w/ clients ever devolve to the facts you recognize in the economy or do you direct them here to avoid that conflict? I ask because this point you discuss was one of the reasons “Rosie” was bearish for so long; i.e. he never thought the missle would launch on its on once the FED booster, QE, dropped off, making your use of his work even more ironic.

  11. gordo365 says:

    I wonder if there is a wealth effect related to raising wages? Personally – a raise in my wages increases my sentiment and spending – more than when the cost of things I buy goes up…

  12. LeftCoastIndependent says:

    Frankly, I think Ben Bernanke has duped all of us into an over inflated equity market with the intention that as tapering continues, we get out of equities and head over to the bond market (safety). The new buyers in bonds will replace the FED buying and rates will stay low, which will help to continue the Main St. economy and housing recovery. Getting into QE is easy, getting out is so hard. This is nothing more than Financial Engineering 101. I’m surprised people don’t see this for what it is. After the tapering is finished, the equity markets will be where they should be, not inflated, and the bond markets will find their equilibrium, whatever rate that is. I gave up guessing at this point. So why is everybody complaining?

  13. SteveC says:

    Thank you for saying what needed to be said. When I was cutting my teeth in the market in the early 90′s, I asked a broker friend why Greenspan seemed so entirely focused on the stock market. I said “why not focus on the economy, and let the market be a reflection of that?” He looked at me liked I had grown a 3rd eye. I didn’t think things would end well with that approach, and I was right. Since Tall Paul stepped down, the Fed has been been way too focused on the stock market. This focus has caused poor decisions to be made. You could argue that Greenspan’s rate cut in Sept 1998, in reaction to a dip in the stock market and his obsession with higher equity prices, led to the dot-com bubble, which led to the housing bubble, and whatever bubble comes next. In their defense this time, though; few seem to understand that we are in a period of time with a very strong deflationary undercurrent. This concept seems well beyond the comprehension of our congressional leaders, many who still have fresh memories of the inflationary period of the 1970′s. I sense the Fed has felt as if they, alone, were the only ones left to keep deflation at bay. And they’re probably right. This deflationary current we’re in will make the process of removing QE very difficult for quite some time.

  14. MinskyMinded says:

    The thought that the Fed is intentionally inflating asset prices is one of the reasons this is “the most hated rally ever”. Earnings have been propped up by deficit spending, while assets have been propped up by money printing. Great sustainable fundamentals for the long-term investor to hang their hats on.

  15. The Fed has spent the last 5 years trying to get the busted banking system back on the road. Propping up the stock market is a way of making sure the banks have healthy capital ratios. So is letting the banks earn fat profits off of steep yield curves, wide lending spreads, and market-trading schemes which are profitable on 90-100% of trading days. ZIRP is a tax on the savers to feed the banks. Interest on Excess Reserves is a tax on the U.S. government paid to the banks. Purchasing of mortgage bonds is used to clean up bank balance sheets (sweep the bad loans from the 2005-2008 period under the Fed’s rug) and keep the housing sector from destroying the economy until the banks are able to lend out mortgages again.

    A fat stock market does a lot for the animal spirits of the stock market investors who are the banks’ victims, I mean cannon fodder, I mean clients.

    If we restored Glass-Steagall, i.e. prohibited the federally insured depository banks from trading in the stock markets, and mandated lower leverage and therefore higher capital ratios, the banks’ health wouldn’t depend on the stock market and the Fed wouldn’t need to pump the stock market to try to pump up the banks.