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Why the ‘Bernanke Bubble’ still haunts Yellen and the Fed

Bernanke, Former Fed Officials Discuss Role Of Federal Reserve In 21st CenturyBernanke, Former Fed Officials Discuss Role Of Federal Reserve In 21st Century
Former Fed Chairman Ben Bernanke.Photograph by Chip Somodevilla — Getty Images

The Federal Reserve is trying to have it both ways when it comes to the market. That could spell trouble.

When Ben Bernanke was the head of the Fed, he used to point to the market as evidence that that U.S. central bank’s policies were working. In late 2010, Bernanke wrote in an editorial in The Washington Post that a rise in stock prices was one of the signals that the central bank’s policies had worked “in the past and, so far, looks to be effective again.” In August 2012, Bernanke told interest rate policy makers at the influential Jackson Hole conference that the Fed’s bond purchases, so-called quantitative easing, had directly boosted stock prices. Bernanke said that was “potentially important because stock values affect both consumption and investment decisions.” And in October of the same year, he reiterated his belief that a higher stock market would boost consumer and business spending. All this talk of the stock market led critics to claim that Bernanke was purposefully blowing a bubble in the stock market.

Now, the Fed is trying to say the market doesn’t matter. The Wall Street Journal reported that during this year’s Jackson Hole conference, which took place this past weekend, a number of policy makers tried to play down the importance of the recent drop in the market. They said it wouldn’t change the Fed’s desire to raise interest rates by the end of the year. Federal Reserve Vice Chairman Stanley Fischer, who was the highest ranking Fed official to speak at the conference (Fed Chair Janet Yellen did not attend), didn’t mention the stock market once in his speech. Instead, Fischer focused on higher inflation, which hasn’t really materialized but Fischer said was coming, as a reason why the Fed would likely need to move forward with a rate increase soon.

It has long been official Fed edict that the U.S. central bank does not react to the market. But in reality, Fed watchers have long understood that the central bank can be swayed by the market. Bernanke, though, made the connection more explicit. He lowered rates swiftly when the market started to tumble in 2008. And he gave some speeches detailing how the Fed had reacted to market drops. And a number of Fed policy makers have talked about how the Fed may want to raise rates in the future to preemptively stop bubbles before they begin to form.

It’s also not unusual for the Fed’s policies to change. In the early days of the Fed, the U.S. central bank was pretty tight lipped. It didn’t even publicly state when it was changing short-term interest rates. These days, the Fed regularly holds press conferences. The fact that they are thinking about raising interest rates is no secret. Fed governors have publicly discussed the matter for months. If anything, these days the Fed talks too much.

But it’s strange that the Fed seems to be flip flopping on the importance of the market, so soon after Bernanke embraced it. The recent move in the stock market does not suggest we are headed for a recession. Even with the 5% drop in August, the stock market’s price-to-earnings ratio suggest that investors still believe that healthy growth is ahead.

But the fact that the market rallied last week when New York Fed Governor William Dudley suggested a rate hike might be on hold, and fell on Monday, when Fischer said it was game on again for a rate increase, says something. (By Bernanke’s logic, the fact that the Fed is planning to raise interest rates is already hurting the economy, I guess.) Rising interest rates should be interpreted as a good thing by the market. It suggests the Fed believes the economy is on solid ground. And while interest rates and stock markets have tended to move in opposite directions over the long haul, in general, when the Fed increases interest rates for the first time in a while, the market has not reacted negatively.

The recent market turmoil suggests that investors don’t believe the economy is on as solid footing as Fed officials seem, or at least would like, to think. The stock market says a lot, and it talks everyday. But, to borrow a phrase, just because the market’s lips are moving doesn’t mean it’s lying. The Fed should listen up.