In my last post (here) I argued that the Fed has seriously over-estimated its understanding of and ability to stimulate the American economy. After several years of engaging in vast policy experiments that have netted it little (but at much risk – see my next post), the Fed has been reduced to the claim that the so-called “wealth effect” will do the trick.
The wealth effect theory goes like this: if the Fed can force up the prices of risk assets like stocks and commodities, people will feel wealthier and spend more and the economy will grow. It’s fairly standard macroeconomic theory, and under more normal conditions it might even hold. But for the Fed to expect the wealth effect to work under the extraordinary conditions that prevail today requires a leap of faith in its own policymaking that seems, well, breathtaking.
In the first place, the wealth effect assumes that people are idiots who can’t tell the difference between a market that is rising for organic reasons and a market that is being brazenly manipulated by the Federal Reserve. In the 1990s the Bull Market in equities did, in fact, make people feel wealthier, leading to the so-called Goldilocks Economy: rapid economic growth with low inflation. Indeed, some people felt so wealthy they quit their day jobs to engage in Day Trading, a sure sign that the wealth effect had wandered into lunatic territory.
But what the Fed giveth the Fed can taketh away. Since the prices of risk assets aren’t rising for organic reasons, but because the Fed is manipulating them (in Fed-speak, the S&P 500 is being used as a “policy tool”), those prices are unrelated to market-clearing prices. As soon as the Fed stops manipulating prices – or as soon as someone notices that the Fed Chairman isn’t wearing any clothes – prices will drop to a market-clearing level (i.e., much lower than they are now). Indeed, someone might even point out that the last time a high government official believed he knew more about where prices should be than the market knew, that official’s named was Leonid Brezhnev.(1)
Some people are willing to play along with the Fed, of course. If the Fed wants to raise stock and commodity prices, these people are thinking, well, why fight the Fed? These people are mainly short- term traders, however, people who are (wrongly) convinced that they are nimble enough to get out before the collapse. But most people aren’t willing to be manipulated, and those people – especially individual investors – have been pulling money out of the stock market by the basketful. Billions of dollars have been yanked out of equity mutual funds and moved into bond funds during the Fed’s use of the S&P 500 as a “policy tool.”(2) Isn’t this, one would think, more or less the opposite of what the wealth effect would predict?
Wealthy investors, of course, are in the business of managing capital and, leery as they are of Fed manipulation, they are less likely to abandon the markets than are middle class investors. But the wealthy don’t drive the US economy – they spend what they spend, regardless of whether stock prices are up or down.
It’s the middle classes – and corporations – whose spending stimulates the economy, and these folks know a rigged market when they see one. The middle class investor votes with his feet, while the corporate investor votes by issuing new, below-market-yielding bonds to replace the market-yielding bonds cluttering up their capital structures. Nice work if you can get it. Besides, most middle income folks don’t have much of their wealth invested in stocks and commodities, but instead in their jobs and homes. Stocks would have to go up a lot higher than the Fed can send them before middle class families would feel wealthier and start spending.
So, yes, the wealth effect can operate under normal conditions. But under rigged conditions, the wealth effect is very likely to be a crock.
(1) There’s an amusing story about Brezhnev and his mother, an elderly peasant lady. Late in his career, Brezhnev brought his mom to Moscow. He showed her around his palatial dacha, wowed her with his priceless collection of foreign luxury cars, fed her courtesy of his private chefs. At the end of her visit, Brezhnev asked his mom how she liked all this. “It’s wonderful,” she said. “But, Leonid, what happens if the Bolsheviks come back?”
(2) I realize that retail investors finally pulled money from bonds funds and dumped it into equity funds in January. Probably a sure sign of a top.
Next up: Is the Fed’s Game Worth the Candle?
Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.