“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.