August 28, 2015 | Commentary on Economic Growth, Federal Reserve

Market Swing No Cause for Fed Action, or Non-Action

Back in grad school (not all that long ago), we pondered whether a central bank should target equity (or other asset) prices to conduct monetary policy.

In theory, as the value of consumers' stock portfolios rise, they will spend more because they are wealthier. It turned out, though, that the empirical link between monetary policy, equity prices, and consumption has always been rather weak.

Nonetheless, Fed Chairs tend to at least mention that they are paying attention to the stock market, even if they're not willing to go as far as Alan Greenspan did with his infamous "irrational exuberance" comment.

No doubt economists will continue to debate this idea. But it seems as though many economists think that, somehow, the "science" on this point is already settled. Indeed, they now assume that the Fed should not only watch the stock market, but move quickly to stamp out market volatility.

In a nutshell, the debate has skipped over whether the Fed should target asset prices themselves, and taken up the question of whether it should respond to short-term fluctuations in asset prices.

Doing so would be a terrible idea. Stock market prices move up and down all the time, for all sorts of reasons, and the Fed's economists are no better than anyone else at understanding why.

More broadly, the stock market is not the economy. Short-term swings tell us very little about the long-term trends in labor markets, prices, and economic growth.

There is no role for a U.S. policy response to short-term fluctuations in the stock market.

Critics will say people lost wealth when the market tanked, so we need a government response. They're wrong.

Anyone investing in the stock market accepts risk, and government guarantees against stock market losses would create even more risk.

Just one or two decades ago, most financial economists would have laughed off the very idea of using monetary policy in this manner, yet here we are.

The notion that government can protect us from every possible loss is a dangerous Utopian fantasy, yet we're much closer to this kind of ongoing government interference than most people realize.

The Dodd-Frank Act expanded the Fed's mandate so that it is now required to safeguard financial stability. The organization now has the broad legal authority to impose rules and regulations on groups of capital market firms in the name of managing this ill-defined concept.

If federal regulators decide asset management firms caused a market decline because they bought assets that were too risky, the Fed could prevent individual investors from ever buying those assets again via a mutual fund. It would no longer be a stretch of their legal authority.

And no matter how absurd this idea would have seemed a couple of decades ago, the media is already reporting that the Fed won't be able to raise interest rates now that the stock market tumbled on Monday.

So we're not too far from the Fed telling us what we can and can't invest in, all in the name of using monetary policy to manage the economy.

Monday's stock market decline, even if it does continue, should have no bearing on the Fed's policy action. And if the market rebounds in a week, that rise should have no bearing on the Fed's course.

The stock market is not the economy, and short-term swings in the S&P 500 or the Dow tell us little about the underlying strength of the economy.

Now, it is true that we should be concerned about the underlying strength of the economy. There's a global slowdown in growth, and that slowdown has many fathers: excessive government spending in Europe and a massive expansion of public and private debt in China, to name just two. But it-and the fragile economy here at home-is also partly attributable to excessive spending in D.C. and excessive regulation of financial markets and the U.S. energy sector.

If policymakers are upset about stock market volatility, they should reverse these policy mistakes. They should implement policies that allow people to keep more of the money they earn, and that allow the private sector to grow without the constant interference of non-productive regulations, paperwork, and bureaucrats.

It's possible that these changes would reduce market volatility, but the ultimate goal is to have stock-market neutral policies. We need this kind of help regardless of what the stock market is doing today.

- Norbert Michel is a research fellow specializing in financial regulation for The Heritage Foundation's Roe Institute for Economic Policy Studies. 

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

Related Issues: Economic Growth, Federal Reserve

This piece originally appeared in Real Clear Markets