Superhero movies usually include a disturbing phase when the savior-figure becomes overwhelmed by opposing forces. But, right now, the market sees no such upset for Brilliant Ben and the Fantastic Federal Reserve, as they continue their rescue of the U.S. economy.
Ben Bernanke's extraordinary policies have undeniably succeeded in persuading investors to plow their cash hoard into riskier assets. The S&P 500 has leapt a staggering 43% in a year. Junk bonds currently yield 5.85 percentage points more than adjusted Treasury yields, according to Bank of America. That is far tighter than the 9.61 percentage points seen nine months after the 2001 recession.| More from WSJ.com: • The ObamaCare Writedowns • Lost Faith in Institutions Hurts U.S. Outlook • Bank-Tax Concept Gains Momentum |
Indeed, only 18 months after debt markets shut down completely, companies now seem to believe that they will be open indefinitely. For instance, Fitch Ratings recently noted that corporate borrowers have started to wait to renegotiate expiring credit facilities, believing they will get better terms in the future.
The bull thesis is seductive. The easy money is creating self-sustaining growth in the real economy that will in turn provide the earnings needed to keep stock and bond prices rallying. And if first-quarter earnings exceed expectations, the upswing will likely continue.
What is obvious, though, is that investors are giving little credence to the idea that the Fed could slip up. Such trust might yet prove justified. A double-dip recession doesn't look imminent. Meanwhile, the market can take comfort from the fact that the Fed hasn't allowed a serious inflation break-out since the 1970s.
But excessive confidence in the central bank nearly always causes the market to overlook harmful economic and financial developments. So, if those materialize, and the Fed suddenly looks fallible, asset prices could be hit.
Mr. Bernanke actually faces several stiff challenges. Individually, they might be navigable. Together they are a big hurdle.
The first: Banks hold about $1.16 trillion of excess cash, which, some fear could be used to fund a potentially inflationary burst of lending. The Fed does have tools to control this huge pool of liquidity, but it has no recent experience of how to do that.
Second is the enormous political pressure to get the unemployment rate down from 9.7%. Granted, some Fed staffers have said that they would hike rates in the face of high jobless rates if the wider economy required such a move. But, on balance, the dovish rhetoric seems stronger. Take Janet Yellen, a regional Fed president who could soon be nominated for the No. 2 post at the central bank. Much of her case for low rates is based on the output gap -- an often flawed approach that attempts to measure the extent to which the economy is running below capacity.
Third, the Fed has to handle the historically large fiscal deficit. By and large, government spending diverts money to unproductive recipients, making the economy more susceptible to inflation. And the deficit is so large that bond investors may yet choke on Treasury debt, forcing longer-term interest rates up. Confronted with that, an accommodative Fed might hold down its short-term rate, which could also stoke inflation.
The bulls, wowed by the Fed's recent actions, will brush off such concerns. But we are getting to the point in the plot where the hero might just meet his match.
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