Hussman Weekly Market Comment: Baby Steps

“The events of the past decade demonstrate the enormous human costs of asset price bubbles and crashes.” – San Francisco Fed President John Williams, September 2013

And yet, here we are again. The Federal Reserve has now enabled the creation of a third equity bubble in hardly more than a decade. It has enabled this, in part, by intentionally targeting equity prices in a vain attempt to create a “wealth effect” that economists have known for decades does not exist – as consumers spend based on their view of lifetime “permanent income” and not based on fluctuations in volatile assets. The Fed has also enabled this, in part, by ignoring the inverse relationship between government/household deficits and corporate profit margins (which make equity valuations seem only modestly elevated on the basis of temporarily bloated earnings, even while stocks remain steeply overvalued on cyclically normalized measures). This week, the Federal Reserve is likely to make a small step toward addressing this mistake.

The breaking news is that Larry Summers has removed himself from the running for Fed Chairman, and while the choice between Summers and Yellen was largely a choice between Scylla and Charybdis, I did prefer Summers, as Yellen is a more conventional Phillips Curve thinker. We now face the prospect of Janet Yellen, who in October 2005, at the height of the housing bubble, delivered a speech effectively proposing that monetary policy could mitigate any negative economic consequences of a housing collapse, and arguing that the Fed had no role in preventing further housing distortions:

“First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble? My answers to these questions in the shortest possible form are, ‘no,’ ‘no,’ and ‘no.’”

Fortunately, the fact is that quantitative easing is largely Bernanke’s beast, making it at least somewhat less likely that other Fed leaders will pursue this policy with the same zeal once he is gone. Indeed, even those who agree with its premises seem increasingly constrained by its already gargantuan scope. A Yellen Fed will almost surely remain interventionist in hopes of affecting outcomes where the Fed’s impact is weak (employment), while taking a benign view toward financial bubbles, resulting in repeated insults to the economy when those bubbles crash. My own preference would have been Martin Feldstein or Thomas Hoenig, but both seem unlikely choices from the President, leaving – among thoughtful choices for Fed Chairman – Roger Ferguson as the most appropriate and politically acceptable alternative to Yellen.