Bernanke: The Markets Will Know When It’s Time to Tighten Policy
It seems like all Mr. Market does these days is harass Federal Reserve Chairman Ben Bernanke about when quantitative easing will be curbed.
In many ways, central bankers are like physicians — and in some ways Mr. Market is a hypochondriac. Markets rely on central bank expertise to diagnose the economic condition, which is essential to understand as the backdrop against which investment decisions are made. In the same way that it’s better to address a sore tooth quickly rather than let it sit and get a root canal later, investors should make sure that Present Them takes care of Future Them by editing their strategies dynamically with changing economic conditions.
Particularly in the second quarter of 2013, investors must remain sensitive to economic conditions. Now more than ever, Mr. Market’s mood fluctuates wildly as improving economic conditions threaten to taper quantitative easing — the unconventional monetary policy that he has become addicted to. The scale and duration of bond purchases, the primary component of the Federal Reserve’s stimulus program, has defined the post-crisis recovery.
Chairman Ben Bernanke’s recent testimony before Congress demonstrated that even nebulous speculation about the future of this program has the ability to send global markets tumbling lower. Japan’s Nikkei fell 7.23 percent the day after the hearing, major European markets fell more than two percent, and in the U.S., Mr. Market’s head was spinning.
The current balancing act between the markets and the Fed is one of information equity. The markets want to know exactly what to expect, and when. Chairman of the Joint Economic Committee Representative Kevin Brady (R-TX) asked Bernanke during a hearing this week how much notice the markets will have of the Fed’s decision to taper purchases, when the time comes to tighten policy.
In January, the Fed adopted an additional unconventional policy and explicitly set a 2.5 percent inflation threshold and 6.5 percent unemployment target as the minimum criteria for a policy rate move. James Bullard, president of the St. Louis Federal Reserve, articulated why setting forward guidance has been a critical part of U.S. monetary policy-making in the post-crisis era.
The great challenge that has faced central bankers over the past few years (as they will be quick to point out) is what to do in a near-zero rate environment. Quantitative easing is one of several unconventional tools on the table, and forward guidance is another. The theory is that extra accommodation “comes from a promise to maintain the near-zero policy rate beyond the point when ordinary policymaker behavior would call for raising the policy rate.”
Ostensibly, this creates a more predictable market environment, which is holistically better for all economic and market participants. The success of this strategy is obviously dependent on the credibility of the Fed — the markets have to believe that it will do what it promises. However, even if the markets trust the Fed, there’s an inherent catch-22 with this strategy: it is only reasonable for the Fed to keep policy accommodating as long as macroeconomic conditions remain poor. Traditionally, central banks have set forward guidance as a function of value over duration — making a set amount of purchases per period, over a set amount of periods.
Adopting this policy creates what Bullard called a pessimistic signal. “In general,” he explained, “any attempt to provide additional policy accommodation today by promising easy policy in the future can be viewed as suggesting the future will be characterized by poor macroeconomic performance. This can be extremely counter-productive, as firms and households may prepare for a prolonged stagnation.”
But by setting forward guidance as a function of labor market conditions, the Fed has managed to avoid the pessimistic signal problem. It is no secret that economic conditions are not as good as they could be, but instead of trying to predict the timeline of recovery, the Fed has taken a “wait and see” approach. Bernanke has made it clear that he is letting the market and the economy inform his decision-making, and that he is not trying to play soothsayer about when conditions will improve.
“The difference with this program,” Bernanke said during the hearing, “is that we are buying a flow rate. We’re buying a certain amount of assets each month, and the amount that we purchase will depend on the data coming in.”
When asked about these benchmarks at the congressional hearing, Bernanke said: “We’re trying to make an assessment of whether or not we have seen real and sustainable improvement in the labor market outlook. This is a judgement that the committee will have to make.” Critically, Bernanke said that if they see enough improvement over the next few meetings, they could bring down the pace of purchases.
Getting back to the question posed to him by Representative Brady — how much notice will the markets have? — Bernanke responded by saying, “Well, we’ve explained the strategy, and the market can see the data as well as we can.”
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