Monday, January 24, 2011

Bernanke Changes His Tune

   Imagine yourself as an investor trying to determine which hedge fund manager is most capable of managing your money. After debating several options you decide upon Mr. Positive who promises stable returns. Mr. Positive outlines the tenets of his fund as seeking to provide returns exceeding those of the S&P 500 with less volatility than the actual index. Halfway through the year, Mr. Positive sends out his mid-year results showing gains of 5% with a volatility slightly above 1 percent per day. These results sound good, but upon reviewing how the benchmark index (S&P 500) has fared over the same period, you learn that the index is up 8% despite volatility below 1% per day. Questioning your decision, you place a call to Mr. Positive and ask why the under performance occurred. Mr. Positive replies that the measures you are reviewing fail to accurately depict the strength of his investment strategy. Mr. Positive explains that during the previous 6 months, assets under management have grown by nearly 20%, showing the true strength of his investment strategy.
   If this were a real scenario (which is certainly possible), it would be understandable for an investor to remain upset with their investment decision. Despite Mr. Positive's arguments for remaining positive, the size of assets under management helps the manager but provides little, if anything, for investors. The above situation was outlined not to bash potential hedge fund managers, but rather mimic the curious adjustment in measuring success outlined in recent comments by the Federal Reserve Chairman.
   The Federal Reserve currently enjoys the dual mandate of maintaining full employment and stable prices (consistent, reasonably low inflation). As unemployment remained near 10% and inflation (core-CPI, the Fed's preferred measure) stagnated slightly above 0, the Fed decided to embark on a new round of quantitative easing in November. Three months later, the unemployment picture has barely budged and the Fed's measure of inflation and outlook remains below their ideal range of 1.7%-2%. In lieu of this data, the Fed Chairman appears to have changed his tune on how the Fed's efforts should be measured.
   In a recent op-ed and interview, Fed Chairman Bernanke argues that the Federal Reserve's policies have been successful, as demonstrated by the greater than 25% rise in U.S. stock markets since announcement of QEII. These statements are especially surprising given their stark contrast with previously established views of the Fed Chairman. For years, Chairman Bernanke has expressed views that the Fed's actions could not be blamed for previous stock market bubbles. Now that Fed policy seems to be driving stock market gains, the Fed Chairman appears very willing to accept the rise as a direct result of the Fed's zero interest rate policy and further quantitative easing.
   Using stock markets as a basis for judging Fed policy not only opposes previous Fed views, but extends the misguided view that stock markets and the economy are one-in-the-same. Stock markets have always been and remain a means for companies to acquire cheap funding and investors to gamble on expectations of future corporate profits. A quick glance at history shows these expectations have frequently proved incorrect, creating little correlation between stock markets and GDP growth. Corporate profits, as determined in a free market economy, show no discretion for equitable outcomes and investors have proved able to value the same profits more or less highly at any given time. As witnessed in the most recent recovery, shedding jobs and lowering wages can vastly increase profitability (at least in the short-run). Energy and food prices have also risen dramatically of late, and while these costs have major effects on the majority of consumer spending, they are not counted as official inflation. Under perfectly normal circumstances, it is therefore possible (potentially likely), that the stock market could rise significantly during periods of high unemployment and high inflation (based on total CPI).
    If unemployment were to run up above 15% with inflation above 4% a year, would the economy still be considered strong? What if the stock market were still rising? Would the Fed's policies then be viewed as effective? These are the fundamental questions worth considering when assuming stock markets are the best reflection of the true economy and measure of Fed policy success. Is it possible that stock market gains will lead to increased investment and reduced unemployment, as Chairman Bernanke hopes...absolutely. However, history suggests the wealth effect is minimal at best, maybe 4 or 5 cents on the dollar. So we return to the fundamental  goals of the Federal Reserve, whose current mandate is to maintain full employment and stable prices. Measuring the results of their policy by any other means is simply misleading.

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