By Anatole Kaletsky
June 20 In the four weeks since Ben Bernanke first mentioned that the Federal Reserve Board might start to taper its program of quantitative easing (QE) later this year, more than $2 trillion was wiped off the value of global stock markets, and probably far more from the value of global bonds, which is harder to estimate.
On Wednesday Bernanke spent almost an hour answering press questions to try to clarify the Fed's policy on interest rates and QE. The result was a further steep fall in equity and bond prices around the world. Does this mean that Bernanke did not really want to signal to, and pacify, financial markets and was trying, instead, to prepare investors for higher interest rates and tougher times ahead? Or is it possible that the market has simply misunderstood his comments, both at Wednesday's press conference and in his statement on May 22?
I have argued repeatedly in this column for the last interpretation: that tapering would not begin before the end of this year and that financial markets have misinterpreted the Fed's intentions, partly for reasons connected with the vested interests of analysts and traders, whose livelihoods depend on convincing the world that economic policy is highly volatile and uncertain.
If monetary policy were predictable and stable, which is essentially what Bernanke has promised, then the status and salaries of Fed-watchers in Washington would be hard to justify and the profits of short-term macroeconomic speculators would disappear. But maybe this view was simply wrong.
After all, equity and bond prices fell further and volatility intensified as investors absorbed Bernanke's hour-long exposition of the Fed's plans. Given that Bernanke has now laid out the conditions for a tightening of monetary policy with unprecedented transparency, precision and authority, investors may simply have concluded that the Fed really will start to taper its monetary stimulus in the near future, contrary to the arguments presented in this column and by many other commentators since May 22.
Goldman Sachs, for example, put out a statement after Bernanke's press conference frankly admitting that their earlier, more relaxed view of Fed policy was wrong and they had changed their minds: "We were expecting a dovish Fed and for Bernanke to calm markets, but got just the oppositethe Fed was more hawkish than expected the risk to our forecast of QE tapering starting in December has increased."
If tapering does start well before the end of the year, this will surely be bad news for financial markets and the world economy. After all, monetary policy is generally believed to be the major force powering global economic recovery and the doubling of stock markets since early 2009. Thus if the Fed really is going to withdraw monetary stimulus earlier than previously expected, it seems logical for both growth expectations and asset prices to fall, and this is exactly what has happened since May 22.
There are, however, two other possible interpretations of this week's Fed press conference. One is that analysts and investors who misread Bernanke's comments on May 22 have done it again this week. The other is that even if the Fed does start to withdraw monetary stimulus before December, this will not prove as traumatic as many investors now seem to believe.
These two issues are closely related. Bernanke was very specific on Wednesday about several key points. He virtually guaranteed that short-term interest rates would remain zero until 2015, regardless of economic conditions. He emphasized that 6.5 percent unemployment was not a target or "trigger" for higher interest rates, but merely a "threshold" before which rate hikes would not even be considered. He added that the Fed's objective was to reduce unemployment to well below 6.5 percent and that monetary stimulus would continue even after this threshold was reached, provided inflation remained below 2.5 percent. And he stated repeatedly that there would be no timetables for reducing the QE program and that tapering would only be considered this year if the Fed's employment and growth forecast objectives were clearly being achieved.
Combining all these promises points to a clear implication. The Fed will only consider reductions in monetary stimulus if employment and economic activity are growing strongly, in line with its latest forecasts, and if there are good reasons for confidence that these positive trends will be maintained.
Given that the Fed forecasts published this week were substantially stronger than the expectations of most market economists, the conclusion that logically follows is that tapering will only happen if the U.S. economy does substantially better than investors currently expect. In other words, either the economy will surprise on the upside or the Fed stimulus will continue at full steam. The one contingency that Bernanke explicitly and repeatedly excluded was that U.S. employment growth would weaken and monetary stimulus would simultaneously be reduced. Yet this is precisely the outcome that many investors and analysts now seem to expect.
Is it really possible that markets have simply misinterpreted something as important as Bernanke's comments on May 22 and are continuing to do so, despite this week's clarification?
Such a suggestion may seem preposterous to believers in the omniscience of efficient markets, but financial markets have made plenty of spectacular mistakes in the past.
The blunders in the ten years to 2008 were mostly on the side of over-optimism: the bubbles in U.S. mortgage bonds, housing and before that internet stocks. Since 2009, however, financial mistakes have mostly been in the opposite direction: refusal to acknowledge the powerful bull market that started in April 2009, exaggerated expectations of a euro breakup, and most recently the unwarranted market panic over U.S. budget deficits and the "fiscal cliff." The instant reaction to Wednesday's comments by Bernanke looks like the latest example of such a bearish blunder.
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