Should the Fed Open a Brokerage Account?By
It wasn’t so long ago that the Federal Reserve left at least some things to the imagination. Was the central bank going to hike rates? Or ease? Did the addition of an adverb in its outlook statement mean it was about to go hawkish? Alan’s Greenspeak was so painstakingly premeditated that it was sanitized of any specific meaning; financial pundits tracked the size of his briefcase.
One Great Recession later, the Fed has pretty much dispensed with that mystique. Chairman Ben Bernanke has pursued three-plus years of zero-interest rate policy, with repeated telegraphing that drinks will stay this cheap until at least 2014. Then add QE1 and QE2 for an extra $2.3 trillion of stimulus. Not good enough? Throw in Operation Twist. And now, Twist, Rinse, and Repeat, even as interest rates just touched record lows. Bernanke has done everything he can to boost this sickly economy.
Or has he?
What if the Fed were to buy stocks? It already buys mortgages—just one way Bernanke constantly blows kisses to the housing sector. But Tobias Levkovich, a strategist with Citi Investment Research, notes that stock market changes have more correlation to consumer shopping activity than changes in home prices. He calculates that the top 20 percent of income earners (who happen to own 90 percent of stocks) account for nearly 50 percent of discretionary consumer spending in the U.S.
Roger Farmer, chairman of the economics department at the University of California at Los Angeles, has been outspoken on the need for the Fed to get more creative by purchasing equities. He writes (PDF):
The [Fed's] credibility issue arises, because, when the interest rate is zero, there is no way to signal a change of policy to the markets using conventional open market operations. The purchase and sale of treasury bills has no effect on the economy, because, when the interest rate is zero, treasury bills and money become perfect substitutes. Monetary policy becomes like “pushing on a string.” That’s where unconventional monetary policy comes in.
Farmer’s research hones in on what he calls the “transmission mechanism” from Fed actions such as QE to the real economy. He views stock market wealth effects as the most important. As evidence, he notes that the Standard & Poor’s 500-stock index bottomed in March 2009, just as the Fed began purchasing mortgage-backed securities. The ensuing one-year bull run, he adds, sharply U-turned in April 2010—coinciding with the removal of the Fed’s program to buy risky assets. In a recent paper (PDF) entitled The Stock Market Crash of 2008 Caused the Great Recession: Theory and Evidence, Farmer offers evidence that U.S. stock market performance has been linked to employment for 60 years.
The economics professor wants the central bank to cut to the stimulative chase by investing in a broad index of U.S. equities. ”It is not just the size of the Fed’s balance sheet that matters,” he says. “It is the composition.”
Of course, this proposition invites tens of questions. When should the Fed buy? If investors are enjoying a rip-roaring bull market run, should the Fed feel obligated to counter that enthusiasm with well-timed sales? Could mere disclosure of these sales prompt a rush to the exits? (Update: The Fed could only purchase equities if the Federal Reserve Act was changed to allow it to do so.)
Even so, the idea of direct central bank intervention in the stock market is not wholly unprecedented. The Hong Kong Monetary Authority did it in 1998, when shares were melting down amid an emerging markets contagion. The practice is old hat for the Bank of Japan, whose chronic zero-interest policy has hardly been enough to jolt the huge economy out of its prolonged slumber. Farmer’s philosophy got a shout-out by an external member of the Bank of England, who in a recent speech (PDF) called for central banks to more aggressively purchase private-sector securities.
The Federal Reserve buying stocks? As unlikely as it seems, it is impossible to count out. After all, the institution is not even 100 years old. The Fed has experienced a Great Crash, Depression, stagflation and, now, all manner of unprecedented interventions toward a Great Recession that is still not in the country’s rearview mirror.