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Bernanke and the Fed finally have a reason for optimism

Consumer confidence matters most

The Federal Reserve has been overly optimistic during this long, slow recovery and—as the Wall Street Journal noted recently—it has been wrong time and time again. And yet, the U.S. central bank has once again embraced a rosy outlook. On Wednesday, it announced things look good enough for it to start drawing down on its $85 billion a month bond buying program later this year.

Has the Fed not learned from past mistakes? Is it going to slip on a banana peel again?

The question—posed in politer terms—came, predictably, from the Journal‘s Fed correspondent Jon Hilsenrath following Federal Reserve Chairman Ben Bernanke’s prepared remarks on the publication of the Federal Open Committee policy statement. This time, Bernanke had a simple, very convincing answer. “One important difference now,” he said, “is that people are more optimistic.”

The chairman returned to that theme several times again during Wednesday’s press conference. He cited the latest reading on the University of Michigan Survey of Consumer Sentiment, which showed that Americans haven’t felt so good since July 2007. He also advanced the hypothesis that growing confidence might be partly behind the recent climb in long-term bond and mortgage interest rates. The increase, he acknowledged, seems larger than warranted by market expectations that the Fed would soon start drawing down on its monetary stimulus.

When asked about why the bank now thinks unemployment might fall at a faster pace than it predicted in March, Bernanke pointed to rising house prices—but not just because of construction jobs. The housing recovery, he said, is restoring the wealth of American families, and—you guessed it—fueling consumer confidence, which in turns feeds into the wider economy through stronger domestic demand. (The chairman also noted that employment levels at state and local governments appear to have stabilized after the massive layoffs of the first years of the recovery. More on that here.)

It makes perfect sense for the Fed to pin its hopes on the improving mood of the average American family, for two reasons. First, consumer demand still accounts for roughly 70% of the U.S. economy. If people buy, the whole private sector gets a boost. That’s how economy was able to avoid another “spring swoon” this year despite the tax hikes and government spending cuts implemented earlier this year.

Second, confidence matters tremendously in financial crises. Research has shown that recoveries from recession triggered by stock market meltdowns tend to be slower, in large part because financial crises shake investors and consumers’ confidence. And those negative public perceptions tend to linger on much longer than fundamentals would suggest. In other words, it is hard to reassure people once they’ve gotten a good scare.

And yet, Americans seem finally reassured. In all likelihood the collective psychological turnaround was triggered by rising house prices, which made people feel wealthier and, in turn, wanting to spend more. As I wrote last week, that’s a bit of an optical illusion, but growing consumer demand and rising home sales are now expected to fuel more hiring by small business. That, in turn, will put more Americans to work and, eventually, push up wages, anchoring the recovery further into the real economy.

The virtuous cycle, it seems, has finally begun. The Fed has reason to be cheerful.

Erica Alini is a California-based reporter and a regular contributor to, where she covers the U.S. economy. Follow her on Twitter: @ealini.