Over the years, the ‘wealth effect’ has been taken as a core component of monetary policy. Central bankers will not admit it, of course, but particularly stock prices are a central element of their strategy. It almost has to be that way given that the modern version of econometrics applies rational expectations theory as a literal condition. Since expectations form the basis of orthodox understanding about how an economy works and why it changes, the biggest effects, economists believe, of any policy are achieved when they impact consumer, financial, or business expectations the most.
So it is with record stock prices. By the nature of the Great Recession in terms of its depth (not that it was actually a recession), monetary policy was hugely constrained in how it might respond. As then-former Chairman Ben Bernanke wrote in November 2010 explaining why QE2 was in his viewnecessary:
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
This post was published at David Stockmans Contra Corner by Jeffrey P. Snider ‘ September 20, 2016.
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