Earlier this month, Harvard Professor Martin Feldstein generated some headlines after declaring on Bloomberg TV "that this is a bubble in the stock market created by low long-term interest rates that the Fed has engineered."
Two weeks later, "a lot of air has come out of the stock market" and Feldstein sees more 'deflation' ahead for one main reason: The Fed is unlikely to do another round of quantitative easing.
While two rounds of QE and Operation Twist have had the desired result -- lower bond yields and a revival of equity prices -- the Fed's actions are "not really moving actual economic activity," Feldstein notes. "Having tried it twice and not succeeded, it's not clear there's any reason for them to do it again."
The former head of Ronald Reagan's Council of Economic Advisers says Ben Bernanke is right that the onus is on fiscal policymakers now. While he wishes otherwise, Feldstein has little faith Congress will tackle the looming 'fiscal cliff' until after the election. (See: U.S. Fiscal Cliff Looms: Will Lawmakers Heed Bernanke's Warnings? )
"There really isn't a policy for the Fed to follow now that can contribute to strength of the economy," Feldstein says, suggesting market players betting on QE3 are going to be disappointed. "If they're counting on QE3, it's not going to happen - that's my bet - then I would say more air is going to come out of the stock market."
While it's impossible to know how the economy would have fared without the Fed's largess, the rate-sensitive parts of the economy, notably housing and business investment, remain moribund. As a result, and because of the economic unrest in Europe, Feldstein predicts the U.S. economy will slow to a 1% growth rate in the second half of 2012.
If he's right about both growth flagging and the Fed standing pat, the air coming out of the stock market could reach gale force.
Asked where the money (and air) coming out of stocks will go, Feldstein chuckles.
"The money doesn't have to go anywhere," he says. "Think about Rembrandt paintings: if people decided they didn't like Rembrandts, the price would fall. You'd wake up and your Rembrandt wouldn't be worth as much. The money doesn't go someplace, it's just that the price tag changes."
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