Love the Fed Rally? Then Hope the Economy Catches Up

Photograph by Kazuhiro Nogi/AFP/Getty Images

It has become the strangest yet most predictable move in this economy: The worse it gets, the higher the market goes. When the economic numbers are bad, the Fed moves in and the markets shoot up. On Thursday we saw this happen right on cue as the Fed announced its latest asset purchase program, aka QE3, as the econosphere calls it.

Bernanke might now be a bogeyman for Ron Paul and other critics of easy monetary policy (a bandwagon Mitt Romney seems to have jumped on), but for the stock market, his policies have worked. Bernanke speaks, and markets go up, in what you might think of as a “Bernanke Rally.”

It makes sense that the stock market would react well to the new asset-purchase policy. The effect is to lower the returns on long-term Treasuries and mortgage-backed bonds and push investors into the stock market. What’s not to like? The question, though, is how long the market can go up even as key economic indicators, such as joblessness, point down.

On this, looking at Japan’s experience is valuable. The term “quantitative easing” comes from Japan, where the central bank increased the money supply by buying up longer-term government bonds—an earlier, less aggressive variant of what the Fed is doing now. From March 2001, when the Bank of Japan put the strategy in place, until March 2006, when it ended, the Nikkei 225 Index rose from 13,000 to 17,059. This wasn’t an uninterrupted rise, but the overall effect on the market seems to have been substantial. That’s especially evident if you start looking from 2003, when Japan strengthened its commitment to the policy.

That’s the markets. For the underlying economy, it’s a different picture. Take a look at this chart, which maps the end-of-year close of the Nikkei 225 to Japan’s national output, or gross domestic product. Even after the market started shooting upward, Japan’s GDP growth was essentially nil.

That the economy should be stagnant during this time isn’t a big surprise: If it weren’t, the Bank of Japan wouldn’t have pursued the quantitative easing policy in the first place. You can blame the policy for the bad economy. You can’t blame the stimulus for this.

The bad news for the markets comes afterward. In retrospect, it’s clear that the markets overshot the real growth. After Japan ceased the policy in March 2006 (whether it was a success is now debated), the Nikkei 225 plummeted. Investors may have gotten a little too used to the central bank’s nectar.

In the U.S., similarly, the stock markets are going up as the rest of the economic data look stagnant, at best. The Fed is letting the markets cash in now on the promise of growth in the future. As Marketplace reporter Heidi N. Moore puts it, the Fed is “giving the markets a sugar rush.” The experience of Japan indicates that this can go on for a while, but the markets that are reaping the fruits of the stimulus now could wind up paying for it later.

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