Markets gave Fed what it needed

The Federal Reserve needed a rebound in financial markets this year to set the table for a lasting economic recovery.

Mission accomplished -- at least with the first half of the strategy.

The central bank’s decision to hack short-term interest rates to near zero -- and to pump more than a trillion dollars into the financial system -- has helped fuel a global feeding frenzy for stocks, bonds, gold and other assets over the last six months.

The rally in stocks gets the most attention, understandably. The Dow Jones industrial average closed above 9,800 on Friday for the first time in almost a year, rising 36.28 points, or 0.4%, to 9,820.20.


The Dow now is up 50% from its bear-market low reached March 9.

But consider what has been happening lately with municipal bonds, a market that you’d expect (and hope) would be less volatile than stocks.

Since mid-August, the share price of the Vanguard California Tax-Exempt bond fund has risen 5%, nearly as much as the 5.4% gain in the Dow index in that period.

Investor demand has been so consistently strong for California state and local muni bonds since early August that the Vanguard fund’s share price hasn’t posted a decline since Aug. 3.


People are snapping up muni bonds because they’re hungry for some kind of decent return on their money, with yields on money market funds and other relatively safe cash accounts so paltry thanks to the Fed’s interest-rate policy.

Overall, the resurgence of financial markets has restored a huge amount of the asset value lost in the calamity of last fall and winter. Even if you’ve done nothing to your portfolio this year, you’re enjoying the benefits of other investors’ renewed appetite for risk.

The U.S. stock market alone has recouped a stunning $5 trillion of paper value since early March, based on the Wilshire 5,000 stock index.

This is exactly what the Fed hoped would happen. Rising investment values can help to quickly build confidence in the idea of an economic turnaround. After all, you are far more likely to at least consider spending money if your assets are rising than if they’re falling. And more spending by consumers who have the wherewithal to do so is what the economy badly needs.

Rising stock prices also give corporate managers more confidence to greenlight business spending decisions.

The markets’ revival “is creating wealth,” said Jim Glassman, senior economist at JPMorgan Chase & Co. in New York. “And that’s the Fed’s intention, even though they don’t want to say it that way.”

Fed Chairman Ben S. Bernanke has needed markets to play along because the banking system isn’t yet responding the way policymakers had hoped. The massive sums the Fed has made available to banks through its various lending programs aren’t translating into vigorous new lending to the real economy.

One measure of that: Total commercial and industrial loans on banks’ books have declined from $1.56 trillion at the end of March to $1.43 trillion as of Sept. 9, the latest data available from the Fed.


“There’s not a whole lot of business lending going on,” said Tom Higgins, chief economist at money manager Payden & Rygel in Los Angeles.

Banks say they’d like to make loans but that potential borrowers are holding back, which probably is true to some extent. But does anyone believe that skittish bankers are eager to lend aggressively after the losses they’ve racked up over the last year?

With overall lending down, banks have to find something else to do with their money. Not surprisingly, some have been happy to sink cash into Treasury bonds, government agency debt and other securities -- helping to underpin the rebound in financial markets.

But as markets have continued their spectacular run this year, the heady gains have put many investors on edge -- and may be doing the same to Fed policymakers.

Wall Street hasn’t suffered even a 10% dip in key market indexes since the rally began in March. The longer stocks go without a pullback, the greater the fear that when a sell-off finally hits it could snowball into something severe.

And with the economy just beginning to climb out of recession, the last thing the Fed needs is for markets to take another huge tumble that would shatter confidence.

Of course, this puts more pressure on the Fed to keep saying what it thinks investors want to hear -- which plays right into the hands of critics who say the central bank is just facilitating another round of asset bubbles.

When Bernanke and peers gather for their September meeting Tuesday and Wednesday, they are virtually certain to leave their benchmark interest rate near zero, because financial markets clearly aren’t prepared for a rate hike even if they believe the recession is over.


The question is whether policymakers will suggest that, with the economy reviving, they should begin preparing to siphon back some of the money they’ve poured into the financial system via their various special lending programs.

Many analysts believe it’s far too soon for the Fed to think about tightening credit in any way.

“It’s true the economy is growing, but we’ve got a long way to go,” Glassman said. “We fell into a deep hole.”

Even so, Bernanke has to be sensitive to critics’ charges that the Fed is poised, once again, to overdo it with cheap money, risking asset bubbles that could end badly.

The Fed has to be grateful that markets have responded as hoped to its all-out efforts to resuscitate the economy. But managing investors’ expectations from this point will be far trickier.