The Exchange

Bernanke’s Real Message: Stop Counting on Us

The Exchange

Investors want transparency. The question is: Can they handle it?

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Reuters

Financial markets across the globe went into a tailspin following the Federal Reserve’s latest policy announcement and the subsequent remarks by chairman Ben Bernanke. The Fed didn’t change its current monetary stimulus measures at all, but Bernanke was more forthcoming than usual about when the Fed might begin to rein in those easy-money policies. He suggested the first small move in that direction could come toward the end of this year, a bit earlier than many Fed-watchers expected.

Bernanke’s enhanced guidance led to a two-day bloodbath in financial markets, with stocks plunging, a gold selloff intensifying and bond yields shooting up. Investors seem to be betting (again) their four-year romance with super-friendly Fed policy will soon end. Since 2009, Fed policy has been the biggest factor pushing interest rates down and stock prices up, so any change, the thinking goes, should have the opposite effect. Within 48 hours of Bernanke’s new guidance, the S&P 500 stock index had lost nearly 4% and suffered its worst trading day of the year.

Stunned investors

Stunned Main Street investors seem to feel Bernanke screwed up, since no policymaker would deliberately cause a stock-market rout. Right? Well, perhaps not. The Fed doesn’t target stock prices per se, but Bernanke may have been trying to send a signal that, in the near future, the Fed won’t have investors’ backs the way it has for the past four years. Bernanke “wanted to inject a higher risk premia and more volatility into the market,” David Zervos, global head of strategy and economics at investing firm Jefferies & Co., wrote to clients. He was “acting against a market that had become too complacent. So far, it appears to be a well executed plan.”

Put another way, the Fed may be concerned investors are making too many bets premised not on market fundamentals but on a continuation of Fed policy. There’s a raging debate about whether stocks are overpriced, and in some ways it’s impossible to tell. Yet even with the latest pullback, stocks are up about 10% for the year; the economy is only likely to grow at around 2.5% throughout 2013.

Super-low interest rates, meanwhile, have been great for borrowers but can also encourage overspending and force some investors to put money into riskier assets than they’d prefer in the hunt for yield. The Fed’s new guidance, wittingly or not, is likely to thin out the flow of credit, since rates have jumped by nearly half a percentage point in just a few days. Since the beginning of May, the average 30-year mortgage rate has risen by nearly a full percentage point.

Since becoming Fed chairman in 2006, Bernanke has pressed for more transparency at the once-inscrutable central bank, initiating regular press conferences and issuing measurable targets that serve as “guideposts,” as Bernanke says, indicating when Fed policy is likely to change. One irony of enhanced transparency, however, is that it may cause more volatility in markets when it allows traders to anticipate changes that haven’t actually occurred yet. That could intensify the types of panicky instincts that have gripped markets lately.

At least one of Bernanke’s Fed colleagues — James Bullard, president of the Federal Reserve Bank of St. Louis — is uncomfortable with the Fed’s newfound transparency and the confusion it may cause. After Bernanke’s latest remarks, Bullard posted an unusual dissent on the St. Louis Fed’s Web site, arguing the Fed should keep its stimulus measures in place and be more circumspect about blurting out the possible timing of policy changes. Of course, Bullard’s statement itself reflects the kind of transparency Bernanke seems to support, as do the frequent criticisms and disagreements senior Fed officials direct toward one another through speeches and other public remarks.

Others feel the markets have overreacted to the latest (non) news from the Fed, since policymakers indicated that while they may begin to wind down some stimulus measures, they may actually extend others. Traders also seem to have ignored many "ifs" in Bernanke's remarks, as if a policy change hinted at in June will be a done deal by December, no matter what. Bernanke didn't exactly say that. Instead, he made clear that the Fed isn't locked into any predetermined course and can change tactics if the economy starts to look better or worse than expected.

No stepping back

Bernanke didn’t come right out and say he thinks markets have become too dependent on Fed policy. But there’s no shortage of critics who feel the Fed has taken too much risk out of investing and therefore distorted the incentives and safeguards that are supposed to govern markets. It’s notable that Bernanke offered similar hints about the Fed “tapering” its stimulus measures in Congressional testimony May 22, which sent stocks down and interest rates up. He could have stepped back from that and reassured markets in his latest remarks, but he didn’t.

Instead, Bernanke gave more specifics about what might trigger a Fed pullback, such as the unemployment rate, now 7.6 percent, falling to 7 percent or so. “With markets on alert for dovish news from the Fed, the actual directive and press conference were mildly hawkish,” Bank of America Merrill Lynch (BAC) economists said in a research note. “The Fed has lower thresholds for tapering than we had originally assumed.” That revelation led Bank of America to predict a Fed pullback will begin in December, several months earlier than the bank had predicted just a few days before.

For all the anxiety they cause, falling stock prices and rising interest rates aren’t necessarily bad for the economy. Many analysts think a modest stock-market correction will generate needed caution and bring stock values more in line with the slower-growing real economy. Even at newer, elevated levels, interest rates remain well below historical averages.

Many investors also have money ready to invest in stocks, which indicates overall optimism about the economy. “We continue to view pullbacks in equities as buying opportunities,” Wells Fargo Advisers (WFC) counseled its clients after the two-day downturn. Just make sure you buy because you believe in the strength of the economy, with or without the Fed’s assistance.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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