Bernanke’s New House of Cards

Friday February 18, 2011.

The Fed’s double mandate is under attack by conservative congressmen.
They want to reduce it to a single one.
Bernanke disagrees.
Two, contradictory mandates is fine with him.
Actually, he singlehandedly added a third one.
On top of full employment and stable prices, the Fed’s responsibility now extends to managing the stock market.

“Our policies have contributed to a stronger stock market just as they did in March 2009.”
The Fed’s Chairman proudly declared in January.
Indeed, the last stock market rally started on September 1, the day after the announcement of QE2.
Unfortunately, so did the rally in commodities.
The Rodgers International Index, which was down 5.5% for the year at the end of August, has been going up ever since.
It is now up 30%, outperforming the S&P.
But that is a coincidence.
Bernanke does not think it is an unintended consequence of QE2.

So, why does the Fed think they need to manage the stock market?
Let’s listen to the Oracle himself:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”
Not so long ago, he would have said “higher housing prices will boost consumer wealth etc..”

At least Ben Bernanke is not hiding his intentions.
Most observers have it wrong.
They think asset inflation is an unfortunate byproduct of the Fed’s loose policies.
Well, think again.
Asset inflation IS the Fed’s policy.
They call it the wealth effect.
It gives people the illusion of being materially comfortable.
This, in turn, stimulates consumption, which becomes the engine of growth.

The wealth effect indeed.
Putin feels it even more.
He may even go on a buying spree for his beloved military.

Can anybody see the flaw in this Houdini-like economic strategy?
Why are there so few people seeing this for what it is:
A house of cards.

Investors learn early in their career that there is no gain until it is realized.
Paper gains are just that.
Many more people learned this the hard way in the last financial meltdown.
The housing bubble made them feel the wealth effect all right.
So they used plastic to spend their paper profits.
We know what happened next.
The profits vanished.
Debt, unfortunately,is more sticky.

Yet, the Fed is at it again!
This time, the assets to be inflated are stocks.
As stocks go up, Ben Bernanke hopes consumers will spend again.
This is the policy.
The implementation is, of course, the harder part.

I tried to imagine myself in Mr. Bernanke’s shoes.
How would I achieve this?
The answer is to create the impression that stocks always go up.
Remember, the wealth effect worked last time because house prices were believed to go only one way: up.

The main tools available to the Fed are the printing presses, interest rates and propaganda.
The printed money could be used to buy Treasuries and thus keep rates low at the long end.
Low interest rates are good for stocks.
But why not use this free money to prop up the market indices?
At the present time, the Fed buys mostly bad mortgages and depreciating Treasuries.
I would also buy stocks.
There are precedents for this in Asia.

So, let’s assume macroeconomic news is bad and there is selling pressure.
I would let the market drop, wait, and slowly push it back up at the end of the trading day.
There is turmoil in the Middle East?
Let the market drop a bit, stabilize and make sure the index ends up on the day.
Inflation is accelerating? Emerging markets are tightening? gridlock in DC?
The market will always come back if I were in charge of the Fed.
Imagine the headlines:
“Stocks Poised For the Longest Winning Streak Since 1936”.
“Chinese Growth Pushes International Markets Up”.
“The Market Looks Past the Chinese Meltdown”.
The sentiment would be that nothing can stop this train.
Prosperity is around the corner.
Join the party.

For the narrative to be supportive, some creativity could help.
Sometimes economic news may be disappointing.
To counter that, I might have to come up with new ways to look at the economy.
If job creation is too slow, for example.
Why not create a new concept, like saved jobs?
I could go in front of Congress and brag about 3 million jobs created or saved.
Even if it is mostly the latter.
That number can be boosted at will, but coming from the Fed’s Chairman it seems legitimate.

Of course, this is just me.
A serious central bank would never do such a thing.
It could be too damaging to his credibility.
Not unlike the way I lost credibility with my wife when I told her I had lost or not gained 50 lbs.

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