Kocherlakota Explains Fed Focus On Stock Market

ppteam

In gauging the success of the Federal Reserve Treasury bond buying program commonly known as QE2, officials like Chairman Ben Bernanke have pointed to a rising stock market as a sign of policy making success.

Against the long course of Federal Reserve history, however, that’s a strange way to justify doing business. For many years, central bankers have declined to comment on the performance of stock markets, and have instead justified their actions in purely economic terms. To the extent financial markets entered into it, central bankers were most mindful of bond markets as the mechanism that translated changes in monetary policy into credit availability for businesses and households.

The stock market only entered into the picture in times of deep market disruptions, or as part of broader discussions about the “wealth effect,” wherein rising stock prices are thought to make households feel richer, and spend accordingly. Of course, stock market operators have always spoken of the a Fed “put,” in which the central bank will ease policy to arrest sustained stock market declines.

All of that has changed since the Fed restarted late last year a program to buy $600 billion in longer-dated government bonds, in a bid to spur higher levels of growth and get the unemployment rate down faster than would otherwise be the case. Many had expected the program to either push down, or moderate a rise in Treasury yields, as the effort did in its first go round. Instead, bond yields curiously went higher, as traders and investors seemed to thumb their noses at the desires of policymakers.

As officials touted QE2′s successes, central bankers did so under terms that clashed with the old way of thinking. In February Bernanke noted that over the course of QE2 “equity prices have risen significantly” and “volatility in the equity market has fallen,” as signs the Fed policy was indeed aiding the economy.

It isn’t clear whether Bernanke’s shift in focus represents a change in how the Fed does business, or whether his comments represent an effort to justify a policy that hasn’t worked as planned, leaving the chairman to support it in whatever way he can. It’s a potentially dangerous policy stance, because if stocks were to undergo an extended period of losses, it could argue for the Fed to keep policy easier than it may want to.

For Federal Reserve Bank of Minneapolis President Narayana Kocherlakota, the increased prominence of asset prices as a focus of monetary policy is not so much an enduring shift in how policy is made, as it is a recognition of what caused the huge economic and financial problems of recent years.

“This recession and the relatively slow recovery we’ve gone through, a lot of it can be traced back to net worth,” Kocherlakota told reporters after a speech in New York Wednesday. “The fall in net worth is what drove us into recession” and “in those circumstances you can see why asset values, both for land and for stocks, are really going to be a central ingredient in the recovery process,” he said.

To ensure the recovery will take hold, it’s important for the Fed to help re-flate asset prices and given households and businesses a chance to rebuild and rebalance their respective financial positions, the official explained.

“In this kind of post financial crisis, post net worth driven recession, it makes sense to be thinking about asset value as a way to try to generate more stimulus than you do in a typical recession,” Kocherlakota said.

The voting member of the monetary policy setting Federal Open Market Committee was careful to note that he was speaking for himself. But even so, his comments suggest that the Fed’s current, unusual focus on stock markets reflects the economy’s particular ailments, and may not prove to be such an explicit part of the policy making regime over coming years.