U.S. Federal Reserve Board chairman Ben Bernanke recently congratulated himself on CNBC for helping boost the Russell 2000 stock index by 30 per cent.
The San Francisco Federal Reserve Bank just published a report that claims the second round of quantitative easing - so-called QE2 - is a success because the U.S. inflation rate is a percentage point higher than it would have been absent the Fed intervention.
Investors should realize how irrational this all is. The United States is in a radical money-easing environment, in which the Fed is keeping interest rates artificially low while pumping money into the economy. This type of policy breeds speculative rallies. It inevitably results in boom-bust cycles such as the ones we saw in 1999-2002, 2006-09 and today. This is no time for short memories.
At best, the Fed has managed to create an illusion of prosperity, but it won't last. And that should surprise no one who has followed the Fed's activities over the past couple of years.
The Fed initially tried to create wealth by reviving the housing market through the first quantitative easing program (QE1), which concentrated on buying mortgage loans. But the foreclosure crisis and the massive excess supply of homes are once again weighing on U.S. real estate values and the Fed has largely given up on reviving that market.
Instead, QE2 has all been about forcing investors to rebalance their portfolios in favour of the stock market. The Fed has no mandate to do this, but it's managed to get away with it by stating that its actions are intended to boost an inflation rate that is too low and veering dangerously close, at times, to deflation.
The Fed's easy-money policies have helped to create inflation in commodities, foodstuffs and stocks. But given the high level of U.S. unemployment, incomes are unlikely to keep up with rising prices, so Americans will be forced to draw down personal savings to maintain their living standards.
Home prices are beginning to fall again and soon we will see the household sector having to rebuild its savings without aid from the government. The view that Washington can take care of everything will disappear with looming austerity, as state and local governments cut back on spending this year, followed by the federal government next year.
Short-term rates at zero, combined with increasing food and energy prices, are bad news for savers. Given the intractable nature of the U.S. fiscal deficit, the Fed needs to encourage more domestic savings but it won't do so, at least for now, because it fears that higher savings will remove demand from the system and exacerbate the trend to deflation.
The Fed is hoping that by boosting the stock market, it can make people feel wealthier and encourage them to spend. This wealth effect may buy time until the market for jobs and homes turns around on a sustained basis.
The offset, though, is that real wages will feel the pinch, not only from high unemployment, which Mr. Bernanke does not see ending for another five years, but from the Fed's own policies that have encouraged the punishing runup in food prices.
I have little doubt this cyclical bull market and stimulus-led economic expansion has been built with straws and sticks as opposed to bricks. Sure, there could be more upside to stocks over the next few months but, at this point, we are probably closer to the peak than many believe.
Tom Hoenig, the president of the Federal Reserve Bank of Kansas City, has been a dissenting rogue on the Fed's Open Market Committee over the past few years, and he has been right. The Fed needs to stop QE2 and raise short-term rates to around 0.5 to 1.0 per cent as soon as possible. Zero rates and asset purchases are fine in a crisis, but they hurt long-term savers and foster inefficient capital allocation.
We have all seen how Fed-induced speculative bull markets end. We either end up with another cycle of wealth destruction down the road or higher inflation. I see no other outcome. As a result, the most prudent strategy for an equity investor is to shift toward hedge funds that preserve capital and manage risk appropriately.
David Rosenberg is chief economist and strategist for Gluskin Sheff + Associates Inc. and a guest columnist for Report on Business.
David Rosenberg