WASHINGTON Federal Reserve officials were clearly taken aback by the selloff that was unleashed in global financial markets when the central bank's chairman, Ben Bernanke, warned that the Fed's bond buying would likely be scaled back this year.
But they can take an increasing level of comfort from having guided Wall Street to a view of future monetary policy that is closer to their own, and the sense that a messy adjustment now is much less harmful than a more violent turn later.
In late May, Bernanke told Congress a decision to scale back the Fed's $85 billion per month stimulus could be taken at one of its "next few meetings." He made the Fed's intentions even clearer on June 19, when he spoke openly of the reduction and eventual end of the program, potentially by mid-2014.
The result was that a yield of 1.62 percent on the benchmark 10-year Treasury note in early May turned into a 2.75 percent yield by the beginning of last week, the swiftest rise in yields in a decade, though the market has since stabilized and the yield was back down to 2.54 percent late on Monday. The shock sent other bond markets tumbling, and global stock markets also plunged initially but have since recovered.
Indeed, U.S. stocks are back around record levels, restoring more than $1 trillion in market capitalization to the S&P 500 index .SPX as investors take the view that the equity market will be able to rally through a reduction in bond buying.
"If I had to guess, I'd guess that members of the Fed are much happier with market levels than they were three weeks ago," said Carl Tannenbaum, chief economist at Northern Trust in Chicago, noting signs that some heavy market bets have eased.
Fed officials did not welcome the steep back-up in bond yields and mortgage rates that Bernanke's remarks caused, judging from the consternation evident in their comments since then to push back expectations of an early Fed rate hike.
That has stoked suspicions that what policymakers were really worried about was a hidden build-up in risk-taking in bond markets that could have been the early signs of a bubble.
"There may have been some concern at the Fed that there was too much risk being taken on," said Scott Brown, chief economist at Raymond James in St. Petersburg, Florida. "They have certainly taken care of that situation."
In the past, monetary policy that has encouraged too much risk has helped to foster bubbles that have burst with disastrous consequences, most recently the collapse of the U.S. housing market that sparked the 2007-2009 financial crisis.
When asked if he wished that he had done things differently, Bernanke suggested roiling markets was a price worth paying.
"Notwithstanding some volatility that we've seen in the last six weeks, speaking now and explaining what we're doing may have avoided a much more difficult situation at another time," Bernanke said at an economics conference last Wednesday, his first public remarks since the Fed's June 19 policy meeting.
But he also emphasized that tapering of the bond buying would not be a signal the Fed would begin to tighten monetary policy sooner by raising the overnight interest rates from near zero, and pointed out that 14 of the Fed's 19 policymakers anticipate the lift-off date for rates will not come before 2015.
The Merrill Lynch MOVE index .MERMOVE1M, which estimates future volatility of long-term bond yields, spiked to around 111 following his June 19 news conference, up from a multi-year low of around 50 at the beginning of May. But it had settled back to around 94 on Monday.
Fed officials saw the low levels of bond market volatility earlier this year as a potentially worrying sign that investors saw bonds as a one-way bet because of the central bank's massive purchases.
Indeed, the nearly 5-month low yield on the 10-year note hit in early May was beneath forecasts for 3-month bill rates over the next 10 years, which is one way analysts compare valuations to figure out if yields are reflecting excessive bets that the Fed will hold rates ultra-low for a prolonged period.
Minutes from the June Federal Open Market Committee meeting showed that two of the 12 voting members felt the Fed should start curtailing bond buying relatively soon to make sure the costs did not begin to outweigh the benefits. All 19 members of the Fed's policy-setting committee participate in the debate but only 12 vote at any given time. The minutes do not mention officials by name.
"Markets seem more able right now to accept the Fed tapering without pricing in ever higher interest rates in response," said Dean Maki, chief U.S. economist at Barclays Capital in New York.
However, with yields clearly higher now than earlier this year, some economists worry the Fed has shot itself, and the U.S. economy, in the foot.
Rising bond yields have pushed up mortgage interest rates, hurting home refinancing activity and threatening to curb housing demand. Rising home prices have been one of the drivers of the economy in the past year.
Executives from two of the largest U.S. banks, JPMorgan Chase & Co (JPM.N) and Wells Fargo & Co (WFC.N), which between them make one in three U.S. home loans, warned on Friday that mortgage lending volumes would decline in the coming months and profits from the business would fall. JPMorgan Chief Financial Officer Marianne Lake said rising mortgage rates could slash volume by 30 percent to 40 percent. That would result in a "dramatic reduction in profits" in the business, JPMorgan Chief Executive Officer Jamie Dimon said.
Some experts say the Fed may be fostering the economic uncertainty it indicates it is trying to avoid.
"They are convinced they are chasing bubbles," said Adam Posen, president of the Peterson Institute for International Economics in Washington and a former Bank of England policymaker. "What it certainly means is that there is a lot more uncertainty about Fed policy going forward."
(Reporting by Alister Bull; Editing by Tim Dobbyn)