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Fed is Too Focused on Wealth Effect, Equity Markets

Posted By Barry Ritholtz On February 6, 2014 @ 10:19 am In Federal Reserve,Philosophy,Really, really bad calls,UnGuru | 18 Comments


“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 [1], 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 [2] 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.

Continue here [3]

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URL to article: http://www.ritholtz.com/blog/2014/02/fed-is-too-focused-on-wealth-effect-equity-markets/

URLs in this post:

[1] wealth effect: http://www.cbo.gov/ftpdocs/77xx/doc7719/01-05-Housing.pdf

[2] economic theory: http://sociology.ucsc.edu/whorulesamerica/power/wealth.html

[3] Continue here: http://www.bloomberg.com/news/2014-02-06/fed-is-misled-by-wealth-effect-.html

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