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Can Fed Draw Virtuous Circle?

TWO momentous events occurred last week, and what was most startling for the financial markets was that they were so utterly predictable. As if on cue, the markets rose.

First, in the midterm elections on Tuesday, Republicans gained control of the House of Representatives, dividing the government and conjuring the prospect of more political gridlock — which Wall Street traditionally sees as good for the markets. (In a recent column, I pointed out that gridlock hasn’t actually helped long-term returns, though many investors believe it has.)

Then, on Wednesday, the Federal Reserve announced the start of a second round of quantitative easing — unconventional purchases of hundreds of billions of dollars worth of longer-term Treasuries. Anticipation of that move had sent the markets rising since late August, and the actual announcement provided an extra boost.

This kind of exuberant market reaction was exactly what Ben S. Bernanke, the Fed chairman, had intended all along: on Thursday, in an op-ed article in The Washington Post, Mr. Bernanke said as much. In his essay, he took the unusual step of analyzing his agency’s own policy rather than leaving the tea-leaf reading to pundits, as his predecessor, Alan Greenspan, typically had done.

Instead, Mr. Bernanke took direct issue with inflation hawks by asserting that the Fed’s unconventional policy would not “lead to excessive increases in the money supply and ultimately to significant increases in inflation.” Rather, he said he envisioned a “virtuous circle” of “higher incomes and profits” that would “support economic expansion” and “promote increased employment and sustain price stability.”

What would propel this virtuous circle into motion? “Higher stock prices,” Mr. Bernanke said. They “will boost consumer wealth and help increase confidence, which can also spur spending,” he added...

AND Lakshman Achuthan, the managing director of the Economic Cycle Research Institute, a private forecasting group, said the Fed’s quantitative easing might end up doing more harm than good. Why? Because the economy is already recovering at a sluggish pace, he said, even if it hasn’t been vigorous enough to cut unemployment, which remains at 9.6 percent. By easing policy now, he said, “you have to consider that they may introduce instability — and not greater stability — in the economy, and create a more extreme boom-bust cycle than we would ordinarily have...”