By John H. Makin
During testimony to the Joint Economic Committee on the economic outlook Wednesday, Fed Chairman Ben Bernanke made a rare misstep. He left markets confused as to where Fed policy was headed. Here were the headlines in various newspapers Thursday morning:
- WSJ: Fed leaves market guessing
- New York times: Fed endorses stimulus, but message is garbled
- Washington Post: Fed’s mixed message takes stocks on a wild ride
These are not headlines that any Fed chairman wants to see on a day after a testimony at a time when there is a great deal of uncertainty about the path of the economy and about the path of monetary policy.
The problem arose when Chairman Bernanke was answering a series of probing questions by Joint Economic Committee Chairman Kevin Brady (R-Texas). Bernanke had given a very dovish testimony, suggesting that the Fed was not about to step away from aggressive QE until the economy improved substantially.
But during the Brady Q&A, Bernanke muddied the waters. When Brady asked Bernanke when he expected to slow stimulus, Bernanke answered: “We could do it in the next few meetings.” When Brady became more pointed and asked whether such a tightening move could happen before Labor Day, Bernanke replied – and here is the real problem – “I don’t know; it’s going to depend on the data.”
My guess is that, in Bernanke’s mind, the data will not justify any easing by Labor Day or, for that matter, before 2014. That was the message in his prepared testimony. But under questioning from Brady, a skeptic on the effectiveness of QE, Bernanke was reluctant to suggest that the economy wouldn’t be better by labor day. That would suggest that QE had done no good to date and that the economy was not improving.
After Bernanke’s initial, written, doveish testimony, the stock market jumped and interest rates fell in anticipation of continued QE from the Fed. However, after Bernanke’s muddled replies to Brady’s pointed questions, the stock market dropped and interest rates jumped. Today after a further sharp overnight drop in stock markets, as elevated uncertainty caused many investors to exit risky assets, the difficulty of Fed tapering its QE is highlighted. Given the rapid run-up in the stock market to date this year, by more than 15 percent, ambiguous Fed comments about tapering lead to sharp corrections which can erase much of the wealth and confidence that has been aiding the recovery.
The underlying problem is the Fed’s use of experimental means to stimulate the economy that have enjoyed only limited success. The stock market has gone up a lot, but the underlying economy has not improved much, and there is a dilemma that was underlined by Bernanke’s answers to Brady’s questions. If the economy stays weak and the gap between the stock market and the real economy grows, the Fed will stay accommodative with a policy that has been helping stocks, but not the economy. However, if the economy should improve, and reinforce the hopeful message from heretofore rising stocks, the Fed will take away the punch bowl by removing some QE.
In Mr. Bernanke’s mind, less QE is simply less stimulus. But in the markets’ mind, less QE is the start of a move down the path toward restrictive monetary policy. Markets levitating on easy money will not be able to stand it, and the Fed will face a dilemma. If they stay accommodative with a recovering economy, inflation will rise and they will be forced to tighten sharply after markets have risen even further. That outcome would mean a bear market: a drop in stock indices by more than twenty percent.
The market turmoil following Bernanke’s testimony on the economic outlook underlines a serious problem. No one really knows how the exit from the Fed’s accommodative QE programs is going to work. Just touching on the subject during his Q&A with Chairman Brady, Chairman Bernanke reawakened all of the uncertainty about just how the “exit” from QE will work and what the impact will be on markets and the world economy.
The Fed is left with a need to “clarify” what its intentions are. Most Fed members, trying to calm jittery markets, will probably come out and say that they expect to remain accommodative for some time. Reassuring comments may help markets recover, but the uncertainty will remain that someday the Fed will actually have to exit its accommodative strategy. That remains a serious problem, one that was underlined by the tumultuous reaction to Chairman Bernanke’s May 22 testimony to the JEC.
John Makin is a resident scholar at the American Enterprise Institute