As the Fed’s leadership passed to Ben Bernanke in 2006, market-friendly monetary policy entered an even braver new era. The bursting of the Greenspan housing bubble triggered a financial crisis and recession the likes of which had not been seen since the 1930s. As an academic expert on the Great Depression, Bernanke had argued that the Fed was to blame back then. As Fed chairman, he quickly put his theories to the test as America stared into another abyss. Alas, there was a serious complication: with interest rates already low, the Fed had little leeway to ease monetary policy with traditional tools. So it had to invent a new tool: liquidity injections from its balance sheet through unprecedented asset purchases.
The experiment, now known as quantitative easing, was a success – or so we thought. But the Fed mistakenly believed that what worked for markets in distress would also spur meaningful recovery in the real economy. Moreover, just as it did when the dot-com bubble burst in 2000, the Fed kept monetary policy highly accommodative well into the post-crisis expansion. In both cases, when the Fed finally began to normalise, it did so slowly, thereby continuing to fuel market froth.
From bubble to bubble
Here, too, the Fed’s tactics owe their origins to Bernanke’s academic work. With his colleague Mark Gertler of NYU, he argued that while monetary policy was far too blunt an instrument to prevent asset-bubbles, the Fed’s tools were far more effective in cleaning up the mess after they burst. And what a mess there was! As Fed governor in the early 2000s, Bernanke maintained that this approach was needed to avoid the pitfalls of Japanese-like deflation. Greenspan concurred with his famous “mission accomplished” speech in 2004. And as Fed chairman in the late 2000s, Bernanke doubled down on this strategy.
For financial markets, this was nirvana. The Fed had investors’ backs on the downside and, with inflation under control, would do little to constrain the upside. The resulting “wealth effects” of asset appreciation became an important source of growth in the real economy. Not only was there the psychological boost that comes from feeling richer, but also the realisation of capital gains from an equity bubble and the direct extraction of wealth from the housing bubble through a profusion of secondary mortgages and home equity loans. And, of course, in the early 2000s, the Fed’s easy-money bias spawned a monstrous credit bubble, which subsidised the leveraged monetisation of housing-market froth.
And so it went, from bubble to bubble. The more the real economy became dependent on the asset economy, the tougher it became for the Fed to break the daisy chain. Until now. Predictably, the current equity market rout has left many aghast that the Fed would dare continue its current normalisation campaign. That criticism is ill-founded. It’s not that the Fed is simply replenishing its arsenal for the next downturn. The subtext of normalisation is that economic fundamentals, not market-friendly monetary policy, will finally determine asset values.
Just as Paul Volcker had the courage to tackle the Great Inflation, Jay Powell may well be remembered for taking an equally courageous stand against the insidious perils of the Asset Economy. It is great to be a fan of the Fed again.
Stephen S. Roach is a faculty member at Yale University and former chairman of Morgan Stanley Asia.
from Just News Viral http://bit.ly/2BH7OzJ
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