Three months ago Ben Bernanke gave a series of lectures and defended the Fed’s actions during the financial crisis. In what was tantamount to a post-crisis victory lap, Bernanke contended that “we did stop the meltdown”, and “we avoided what would have been, I think, a collapse of the global financial system.” These sentiments echoed similar self-congratulatory remarks made by Mr. Bernanke in 2011 and 2010. For that matter, they mirrored those made by Bernanke as far back as August 2009:
“History is full of examples in which the policy responses to financial crises have been slow and inadequate, often resulting ultimately in greater economic damage and increased fiscal costs. In this episode, by contrast, policymakers in the United States and around the globe responded with speed and force to arrest a rapidly deteriorating and dangerous situation...As severe as the economic impact has been, however, the outcome could have been decidedly worse. Unlike in the 1930s…” August 21, 2009. Bernanke
And yes, whenever Bernanke mentions the ‘1930s’ it is time to simply add yada, yada, yada...
But I Thought The Crisis Was Over?
Last week Bernanke announced a continuation of the Fed’s maturity extension program (or ‘operation twist’) and stressed that the Fed was ready to do more. Nearly 5-years since the Fed’s first rate cut - and with the Fed unable to exit any major stimulus scheme - the committee is getting ready to launch QE3?
“Interest rates are quite low…I think we can lower interest rates more” (and related quotes below) Bernanke. Q&A June 19, 2012
Be it because of the lack of ‘transmission’ (of low interest rates into the economy) or the insistence by Bernanke that the Fed can do more, the Fed’s twist extension did not pack the psychological punch of previous stimulus schemes. In fact, reporters questioning Bernanke ignored the twist almost entirely, instead asking questions like: “if you expect inflation to remain under control and the jobs market is by all accounts weak, why doesn’t the Fed unleash another round of stimulus now?”
With reporters vying for clues on the ‘when’ (QE3) and Bernanke doing his best impression of Greenspan, the question of ‘what’ didn’t get much attention. More Fed’ asset purchases may be around the corner, but what assets are to be purchased?
“Additional asset purchases would be among the things that we would consider if we need to take additional measures to strengthen the economy…”
“I wouldn’t accept the proposition that the Fed has no more ammunition. I do think that our tools, while they are non standard, still can create more accommodative financial conditions…”
“We still do have considerable scope to do more and we are prepared to do more…”
“We are prepared to do more…each of these non standard programs does have various costs and risks associated with it…”
“the types of unconventional programs that are available are, um…we know less about them, they have various costs and risks”
Are Equities Next?
QE1 and QE2 were successful, at least in the Fed’s mind, because these programs had a positive impact on asset prices (i.e. stocks and real estate). If a short term rise in asset prices measures success, logic dictates that falling asset prices are an indication of failure. For example, what if the S&P 500 falls below the level it was at prior to QE2 before the Fed can start its exit strategy? Doesn’t the Fed parroting ‘things would have been worse if we didn’t print’ lose all meaning if things get worse shortly after trillions of dollars are printed?
“We think that…QE1 and QE2 did have significant effects on assets prices…”
Seemingly too simplistic, the reality is that stocks are one of the most important indicators to the Fed. This is the case not only because stock prices provide an immediate indication of how Fed policy is being received by investors, but also because (by many accounts) stocks are the best ‘transmission mechanism’ when it comes to juicing the economy. Whereas record low interest rates have the potential to stimulate economy, rising stock prices absolutely increase household wealth (at least on paper).
“What the Federal Reserve is doing with the program we announced today…is we are taking longer-term debt off the market in order to induce investors to move into other assets…”
According to Fedthink, in order to be successful QE3 needs to ‘induce’ more investors into ‘other assets’. Given that there are only two assets the Fed cares about – real estate and stocks – It is not difficult to envision an equity downturn that compels the Fed to enact a stock buying program.
“We are unlikely to do more maturity extension for awhile because we have taken that about as far as we can” June 19, 2012
As for the notion that Bernanke will refrain from stuffing the Fed’s already bloated balance sheet with equities for fear or causing a panic and/or because of the obvious absurdity of mirroring a Japanese-style intervention template Bernanke has heaped scorn on, remember to keep it simple: The Fed prints and asset prices rise.
“First, to be very clear, the purpose of monetary policy easing is not to increase stock prices per se, the purpose is to strengthen the U.S. economy, put people back to work, and create price stability. But, the way monetary policy always works is through interest rates and asset prices -- that's how it always works -- by changing those prices in financial markets. “ Bernanke Feb 3, 2011
What if you print trillions of dollars, keep short term interest rates at zero percent, and asset prices still do not listen? If you are central banker thought by many as the authority on the Great Depression, you stop fretting over the irrational inaction of tone-deaf investors and instead ponder taking the plunge…