The Federal Reserve’s Third Mandate

| January 15, 2011

Federal Reserve Chairman Bernanke has stated unambiguously that the latest round of quantitative easing targeted the stock market along with interest rates. The goal was to inflate equity valuations and thereby fuel a “virtuous cycle” via the wealth effect. This apparent new third mandate of the Federal Reserve was discussed by John Mauldin in his weekly newsletter this weekend.

The Fed has two mandates: keeping prices stable and creating an economic climate for low unemployment. I am sure I was not the only one to listen to Steve Liesman’s interview of Ben Bernanke this week and shake my head at the spin he was giving us. First, let’s set the stage.

In a paper with Alan Blinder early last decade, Bernanke made the case for the Fed to target a specific inflation number, and the number that came to be accepted as his target was 2%. In his famous helicopter speech in late 2002, he assured us that inflation could not happen “here,” even if the short-term rate was zero, because the Fed would move out the yield curve by buying large amounts of medium-term bonds. This would have the effect of lowering yields all along the upper edge of the curve. This became known as quantitative easing. In Jackson Hole last summer, he made very clear his intention to launch a second round of liquidity-injecting quantitative easing (QE2). In that speech, in later speeches in the fall, and in op-ed pieces he said that such a program would lower rates.

Then a funny thing happened on the way to QE2: long-term rates began to rise all over the developed world. As Yogi Berra noted, “In theory, there is no difference between theory and practice. In practice, there is.” It’s got to be driving Fed types nuts to see the theory of QE, so lovingly advanced and believed in by so many economists, be relegated to the trash heap, along with so many other economic theories (like that of efficient markets). The market has a way of doing that.

So, Liesman asked Bernanke about one minute into the clip about the little snafu that, following QE2, both interest rates and commodity prices have risen. How can that be a success? Ben’s answer (paraphrased):

“We have seen the stock market go up and the small-cap stock indexes go up even more.”

Really? Is it the third mandate of the Fed now to foster a rising stock market? I wonder what the Fed’s target for the S&P is for the end of the year? That would be an interesting bit of information. Are we going to target other asset classes? Understand, I am not against a rising stock market. But that is not the purview of the Fed. And certainly not a reason to add $600 billion to the balance sheet of the Fed when we clearly do not understand the consequences. If it looks like they’re making up the rules as they go along, it’s because they are.

The main problem facing our economy from a structural growth perspective is massive public and private debt. The last time we found ourselves in this position was during the Great Depression, and it took us twenty years to purge the speculative excesses from the system and begin the next secular expansion. At the time, we attempted to solve the issue by flooding the system with liquidity, in much the same manner that we are doing so today. However, when debt levels become this excessive, the only way to fix the problem is to materially reduce debt, period. It is a well-established fact that you cannot solve an excessive debt problem with more debt. Unfortunately, this is a lesson that we have yet to learn. Granted, short-term fixes may feel better for a little while, but they only provide short-term relief. Quick fixes ultimately serve only to increase financial market volatility and instability, fueling violent swings both higher and lower while delaying the inevitable debt reduction process. The longer we persist in applying short-term solutions, the longer it will take to create the foundation for the next structural growth cycle.

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Category: Commentary, Market Update

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