The Fed wants asset price inflation not consumer price inflation

The Fed’s intent is not to create consumer inflation, but rather asset inflation — primarily in the equity market.  By pulling longer-term bond yields lower, the Fed hopes that this will alter how investors value equities relative to the fixed-income market.  Moreover, the Fed will be actively pushing up the value of bonds that exist in investor portfolios, and as such the intent is to induce these investors to rebalance their asset mix towards equities in order to maintain their current allocation.  The Fed is also trying to incentivize fund flows into the equity market. This in turn would theoretically boost household wealth and as such make  consumers, who now feel richer, to go out and spend more.  So the theory goes  — we shall see how it works in practice. 

The Fed’s intent is also to lower both the debt and equity cost of capital so that companies will, at the margin, compare that to expected returns on newly invested capital and begin to spend more on new plant and equipment.  The hope here is that the investment spending multiplier will kick in and that stepped-up job creation would occur in tandem with the renewed capex growth.

–David Rosenberg, Gluskin Sheff’s Morning Note, 18 Oct 2010

Here’s my take.

The Federal reserve is principally concerned with asset prices, as it has been since the days of Alan Greenspan. If you recall, during the days under Sir Alan’s helm, the Federal Reserve would increase interest rates in baby steps when the economy showed signs of overheating. But the Fed would flood the market with liquidity and lower rates drastically when a recession hit. Lax on the way up and loose on the way down. This was known as the Greenspan Put because it gave investors a sense that there was a floor on stock prices.

Today, the Fed is still trying to reflate the asset-based economic model with PZ money (permanent zero – where extended period language is perpetual). But low Treasury rates affect not only stocks but mortgage rates as well – and this is important in the context of a still dysfunctional housing market. So the Fed certainly wants stocks and bond values to go up, boosting household wealth and hopefully aggregate demand with it. Notice that this also works at odds with deleveraging and with increasing the savings rate. As Rosenberg says, the low rates may also have  the benefit of increasing capital spending (even though there is a tremendous amount of excess capacity). I remain sceptical.

Update: I should also point out that David Rosenberg believes fiscal policy is more effective than  monetary policy but that it is off the table for political reasons. He writes:

The U.S. economy is caught in a classic liquidity trap. With additional fiscal stimulus no longer a viable political option, even though the government is better equipped to deal with many of the structural hurdles to growth than monetary policy, Mr. Bernanke clearly feels that the Fed is the only game in town. Although, the White House does seem set to push, yet again, for a $250 bonus to the country’s 58 million Social Security recipients. Mr. Bernanke so eloquently outlined the risks associated with QE2 last Friday, but he obviously believes that the cost of doing nothing outweighs the risks. But he also knows that there is a chance that QE2 will only be met with limited success — monetary policy, even in a non-conventional form, is a very blunt tool to use to reverse a secular uptrend in the savings rate, re-dress chronic unemployment or induce people to spend rather than correct their debtladen balance sheets."

Asset values can increase in real US dollar terms! That’s apparently what the Fed cares about.

In any event, I am not certain the Fed doesn’t want a bit of consumer price inflation too given the high debt levels in the US. However, the first priority for the Fed is boosting aggregate demand and that demands a sprinkle of easy money, and maybe just a dollop of quantitative easing too. Foreign concerns don’t enter into the mix. But, right now American investors like this mix and are saying,"Bartender, pass the punch bowl."