The Fed's QE2: Boosting Stocks -- and 'Animal Spirits'

Wall Street has no lack of superstitions or old sayings. Traders try to read the rest of the year by January's performance, they worry about trading patterns like "Death Crosses" and they think it's smart to "sell in May and go away."

Despite the questionable track record of such "wisdom," investors would be wise to take one long-established truism seriously. The old admonition "don't fight the Fed" continues to stand, and Thursday's 220-point rally in the Dow Jones industrials following another round of quantitative easing by the Federal Reserve again demonstrates its merits.

Much of the speculation about the Fed's intentions tends to focus on its views of inflation as compared to unemployment, and understandably so. After all, the central bank's dual mandates are to ensure as much resource utilization as possible while maintaining price stability. And the Taylor Rule usually forms the backdrop of gaming most Fed thinking.

A Powerful Combo

But while the Fed tends to concentrate on these lofty macroeconomic relationships, some signs show that it's increasingly targeting a far more haphazard arena as well. The Federal Reserve seems to becoming increasingly aware of the big impact that rising "animal spirits" (in John Maynard Keynes's famous words) can have on the stock market and, in turn, the broader economy.

Investors should be aware that strong fundamentals like earnings combined with a Fed eager to boost stock prices could create a powerful combo. And that could lead to a boost in animal spirits.

In an op-ed for The Washington Post, for example, Fed Chairman Ben Bernanke ticks off the usual reasons for pushing down interest rates further: Lower rates on everything from mortgages to corporate loans should help the housing sector and boost business investment.

However, buried at the bottom of his list, the biggest self-perpetuating boom seems to come from rising stock prices. "And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending," Bernanke wrote. "Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

Boosting the Wealth Effect

Most people on Main Street see the stock market as a reflection of business conditions, but top policy officials like Bernanke are well aware of its ability to shape a self-fulfilling prophecy.

Indeed, prior Fed Chairman Alan Greenspan said so rather plainly in July, when the stock markets had seen a sharply rally during prior months, hiring was picking up steam and the country's economic spirits seemed to be on the mend: "While ordinarily we're seeing the stock market driven by economic events, I think it's more the reverse. What we do know is stock prices are a leading indicator."

The impact of the so-called wealth effect has fascinated Fed officials for some time. Central bank forecasters internally presented a newspaper clipping showing a boom in luxury boarding kennels more than a decade ago, for example, by including a photo of a dog with a caption that read: "I sure enjoy consuming master's recent stock-market gains!"

Sponsored Links

The view also touches on the long-held beliefs of some of the world's most successful speculators. Hedge fund legend George Soros has long pushed his theory of "reflexivity" as a counter to textbook economics. Soros contends that, unlike in the natural sciences, the social sciences consist of a feedback loop where participants' behavior is constantly modified by the outcomes they witness, and that in turn influences outcomes.

Like Greenspan before him, Bernanke also seems highly skilled at gaming market expectations. The $600 billion in new quantitative easing the Fed announced gave a frenetic market just what it wanted. At the same time, the door remains open for further easing should things slow.

In the long list of high-minded concerns that come out of Federal Reserve meetings, stocks are hardly ever mentioned -- let alone animal spirits. Yet investors should note that the august body knows well that boosting stocks can give the whole economy a big push.