The Exchange

Jumping to the Fed’s Conclusions

The Exchange

By Terry Connelly

Ben Bernanke – academician that he is – runs the Federal Reserve more like a dean of a faculty than a CEO, or a Greenspan.

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That means plenty of debate, give and take, conflicting opinions and even open dissent is tolerated and even encouraged by the Chairman. Not only does he not fear such apparent disunity and mixed messages, he understands that the tendency of faculties to want to “debate everything and decide nothing” leaves a typical dean more room to maneuver, and ultimately control, the actual direction, choices and timing of policy.

The Chairman has followed this pattern for almost two full terms, and the financial markets should have figured it out by now. But they haven’t really, and that spells trouble for them and us humble investors if they keep jumping to unwarranted (if momentary) conclusions about the direction of Fed policy whenever the Reserve Board’s discussion minutes are released, on one or another “hawk” or “dove” expresses an opinion.

Even when Bernanke himself goes on the record as required for Congressional testimony a couple times a year, or in his quarterly post-meeting press conferences, there is way too much speculation about whether the Chairman will let slip some market-moving hint about the future actions of the Fed on interest rates – or most recently regarding the duration of its bond-buying ‘Quantitative Easing” stimulus program.

Many market sages unfortunately fail to appreciate the full meaning of the “Chairman as dean” dynamic. The corollary to Bernanke’s tolerance of publicly divergent views among the Fed Board members and regional Fed Bank governors is the commitment of the Chair/dean never to get out ahead of his Board/faculty. If Bernanke did let some advance signal slip, he would be breaking the very compact that gives him the flexibility and control to be the ultimate “decider” – but only after all other voices have been heard out (even ad nauseam).

The Fed itself is perhaps more aware of the market’s tendency to jump too aggressively to conclusions than market participants themselves. The Board is struggling mightily to craft a communications policy and practice that will give the markets plenty of advance notice of future policy moves without driving investors in either stocks or bonds (or houses) prematurely to the potential end-point of such moves, and taking the markets to unwarranted extremes as a result.

For example, in recent days the markets have jumped back and forth on readings taken of speeches by various Fed officials where the tea leaves could be read either way respecting if and when the Fed will begin “tapering” its program of $85 billion monthly purchases of mortgage and Treasury securities. The needle didn’t move all that much on the Dow – about a range of 100 points – but enough to make Fed officials ponder “long and hard” as one later said about how it would actually communicate a real turn in direction (like, say, a modest change in the amount of monthly bond purchases) without driving market reaction to reflect an extreme end point (e.g., complete withdrawal of Fed stimulus) policy that the Fed may well not have yet determined.

That markets are quite capable of leaping to that sort of unwarranted and wholly counterproductive (in terms of the Fed’s objectives, if not those of market short-sellers) conclusions ought to be clear by now. We have seen that movie before.

Individual stocks routinely overshoot upward and downward on the basis of earnings forecasts and analyst upgrades and short squeezes. Algorithm-driven nano-second trading programs sometimes jump to false “conclusions” they themselves have set up, and by virtue of their predetermined hair-triggers pegged to ultra-short term pricing changes can exacerbate even modest momentary market panics into full-scale routs. Imagine how such high-powered trading may be programmed to respond to a mere "turn signal" from the Fed, even well before it reaches the corner or actually moves to the turn lane!

Chairman Bernanke wants to control the reaction to Fed policy decisions with far more precision than that. The dean’s tricks in controlling his faculty may not work so well with the market "students" – especially when many of them are pre-programmed to suspect the “dean” may be making the wrong move, or at least a late move.

It has been fashionable in some market quarters to subscribe to the ideology that “the Fed – and/or Bernanke – can do no right.” The emergence of rampant inflation as a result of the Fed’s stimulus programs has been predicted repeatedly for nearly the entirety of the Chairman’s second term. It’s a better way to get on television than simply repeating the old mantra, “don’t fight the Fed.” And there are reasons to doubt Bernanke’s judgment from the early days of the financial crisis, when the Chairman opined that the subprime mortgage finance crisis was likely “contained.” But he is also a Chairman who has learned from the mistakes of others (he earned his PhD on that), and of his own doing (like prematurely ending QE I). He is not likely to be premature as long as he is in control, dissent or no dissent: as a “dean,” he doesn’t really care about dissent, as long as he is the “decider.”

A clear example of the kind of market overreaction the Fed is concerned about came when the Dow moved 75 points down in an instant just because the Chairman, in answer to a question during his Congressional testimony, indicated that QE tapering could occur sooner than anticipated – but only because the economic outlook data became much more positive quicker than anticipated. Meanwhile, he had also indicted that it would take a period of consistently positive data (a close colleague quantified this as 3-4 months) to reach such a conclusion.

The market should realize the simple mathematical fact that a tapering of QE purchases from $85 billion to, say, $65 billion would be a sudden policy shift to “tightening” but merely a reduction in the pace of “accommodation.” A lighter foot on the accelerator is not the same as slamming on the brakes!

Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.

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