The Fed’s Focus on the “Wealth Effect” Is Idiotic


Washington’s Blog
February 7, 2014

We’ve repeatedly noted that the Fed’s main strategy has been to artificially blow bubbles in asset prices.

Image: Federal Reserve (Wikimedia Commons).

And we’ve repeatedly pointed out that one of the Fed’s main goals is to boost the stock market, yet the great majority of Americans – the bottom 90% – own less than 20% of all stocks and mutual funds. So the Fed’s effort overwhelmingly benefits the wealthiest Americans, and doesn’t help the general economy.

Barry Ritholtz has a great post at Bloomberg about the Fed’s idiocy of the Fed’s focus on the “wealth effect”:

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

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[What bugged me most about Fed policy] is the Federal Open Market Committee’s focus on the so-called wealth effect, and its corollary impact, the stock market’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.

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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.

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With so few people actually invested in the results of the stock market, how can it have such a broad effect on consumer spending?

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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.

No wonder only higher income brackets like Fed policy.


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