The Fed Tries to Unleash the Economy's "Animal Spirits"

I spent a lot of time reading articles and talking to clients yesterday about the Fed's QE2 announcement. My bottom line remains that the Fed wants stock prices to move higher, and interest rates to move lower, and for the time being investors shouldn't "Fight the Fed".

Meanwhile, I am still struggling to understand what Bernanke & Co. are trying to do.

One explanation might be found in a book published about a year ago by Robert Shiller and George Akerlof titled Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism. Here's a summary from Amazon.com:

Akerlof and Shiller reassert the necessity of an active government role in economic policymaking by recovering the idea of animal spirits, a term John Maynard Keynes used to describe the gloom and despondence that led to the Great Depression and the changing psychology that accompanied recovery.

Like Keynes, Akerlof and Shiller know that managing these animal spirits requires the steady hand of government--simply allowing markets to work won't do it. In rebuilding the case for a more robust, behaviorally informed Keynesianism, they detail the most pervasive effects of animal spirits in contemporary economic life--such as confidence, fear, bad faith, corruption, a concern for fairness, and the stories we tell ourselves about our economic fortunes--and show how Reaganomics, Thatcherism, and the rational expectations revolution failed to account for them. Animal Spirits offers a road map for reversing the financial misfortunes besetting us today. Read it and learn how leaders can channel animal spirits--the powerful forces of human psychology that are afoot in the world economy today. In a new preface, they describe why our economic troubles may linger for some time--unless we are prepared to take further, decisive action.

In other words, by targeting asset prices, the Fed is hoping that rising stock prices and improving house prices (by driving mortgage rates lower) will lift some of the gloom pervading the populace, induce more spending and improve economic conditions.

Whether this works or not remains to be seen but it certainly is having an effect. Most of my clients are reluctantly concluding that dividend-paying stocks should play at least some role in their portfolios, even thought all are still rightfully concerned about the economy.

Meanwhile, the rest of the world is furious at the U.S. The FT notes this morning that China, Brazil and Germany, among others, are warning that the Fed's action could lead to a currency war that will hurt the entire global economy. And leaders of several emerging market countries worry that the U.S. moves will lead to massive inflows in their own countries, and hike inflation.

FT.com / Global Economy - Backlash against Fed’s $600bn easing