Yesterday, the stock market (S&P 500) dropped sharply upon hearing Chairman Bernanke’s testimony before Congress in which he declined to promise that the Fed would engage in another round of quantitative easing as many observers were anticipating. The news sent the market tumbling, and the dollar rose 1% against the euro. Readers of a certain age will recall a well-known advertising slogan for a now defunct stock- brokerage house, E. F. Hutton: when E. F. Hutton talks, people listen. Ben Bernanke is not a stock trader, but when he talks, people do pay attention. By day’s end, however, the market recovered a bit of the ground that it lost immediately after Bernanke’s testimony was released, falling by just half a percent. What happened?
My guess is that the markets may have been factoring in two separate pieces of information. The first was the upward revision in real GDP growth in the fourth quarter of 2011 from 2.8% to 3%. Thus, the market was in positive territory before Bernanke’s testified. The news was reflected in rising real interest rates associated with improving expectations of real GDP growth. The improved expectations of future real GDP growth were countered by Bernanke’s testimony, which suggested that the anticipated easing might not be forthcoming. That sent inflation expectations south, and the market followed inflation expectations, as I have found that it usually has done ever since tight money sent the economy into steep decline in the spring of 2008 when the Fed was mistakenly focused on countering rising energy prices instead of supporting a faltering economy.
The combination of the two effects, the improvement in the real strength of the economy, a positive, was more than offset by the disappointment about the future course of monetary policy. The net effect was a slight fall in prices, but it is interesting to see an example of the two effects going in opposite directions on the same day.
Today the market more than recovered yesterday’s losses, the S&P 500 reaching a new post-crisis high. Real and nominal interest rates both rose, reflecting increasing optimism about economic recovery, and inflation expectations were unchanged. So there are some grounds for cautious optimism, but an oil-price shock could stall this fragile recovery yet again, especially if the inflation hawks on the FOMC have their way, yet again.
Uneasy Money 
So I guess that means Mr. Bernanke is walking away from establishing credibility in raising inflation expectations?
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The third round of quantitative easing. There has never been this much money around in history. If anyone had the chance to read Mr. Bernanke books, than you will know that this is not be a surprise. He will continue to inject ever more fiat money. Oil prices are going to skyrock. Who knows 5 dollar a barrel.
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More money is what the doc ordered, and I hope Bernanke uses up a few more dozen oil tankers of ink printing money and then starts issuing scrip.
Milton Friedman went to Japan, under very similar conditions, and told them to print money until they had robust real growth, followed by inflation, and then maybe then start to cool things off.
The title of MF’s publication was “Reviving Japan.” http://www.hoover.org/publications/hoover-digest/article/6549
What irks me is the rice of currency cultist and Theo-monetarists who say we can’t have prosperity as that might lead to inflation. Oh dear! Inflation!
Reminder: The true goal of monetary policy is economic prosperity. I care little if we are mightily prosperous, but run 4 percent inflation. I will cry a Niagara on the way to the bank.
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Julian, Bernanke’s credibility in raising inflation expectations is far from rock solid.
Tas, Injecting money into the system is not the same as getting people to spend it. We could use more spending, the price of oil is now more susceptible to the political situation in the Persian Gulf than the policy of the Federal Reserve.
Benjamin, On message as always.
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