Amid the current turmoil in global markets, one question is being obsessively debated on Wall Street: Just what was Ben S. Bernanke thinking three weeks ago when he said that the Federal Reserve might soon cut back its stimulus efforts?
While second-guessing the Fed is a parlor game that traders have played for decades, it is an exercise that has taken on heightened significance. The reason: In recent years, the markets have been more dependent on central bank support than at than any time in recent memory. So when Mr. Bernanke, the Fed chairman, said that the stimulus might diminish, alarm was bound to spread. And quite a reaction it was. Since May 22, when Mr. Bernanke made the remarks in question, global stock markets have lost $3 trillion in value, according to Bank of America Merrill Lynch.
Mr. Bernanke will get another bite at the apple on July 17 and 18 when he delivers his semiannual testimony to Congress, where his remarks will be closely scrutinized.
Before looking at what Mr. Bernanke actually said in May, it’s helpful to recall some history.
After the financial crisis of 2008, the Fed moved into emergency mode to lift the economy and support the banking system. The central bank has bought more than $2 trillion of bonds, effectively pumping that amount of money into the banking system and economy. The Fed’s latest bond purchase program kicked in this year. But in contrast to its previous programs, the Fed this time did not say in advance how much it was going to spend on bonds. Instead, the central bank said it would keep up its purchases until certain economic targets were achieved. The main goal is to get the unemployment rate down to 6.5 percent or lower. The Fed is also watching the falling inflation rate and will keep buying bonds if that indicator falls to a level that it thinks will weaken the economy and financial system.
Looking at where those two gauges are today, investors assumed the Fed would buy bonds for many months. But that changed when Mr. Bernanke testified before Congress on May 22. He said that if the Fed saw improvement in the economy, and felt it could be sustained, it “could in the next few meetings take a step down in our pace of purchases.â€
The words “next few meetings†were what really worried market participants. They had become accustomed to the Fed’s implacable reassurances that it wasn’t going to change its accommodative stance until the goals had been met. Yet here was Mr. Bernanke seemingly saying that the money spigot could start closing later this year. Their thought process continued: Mr. Bernanke must know how much weight his words carry, and he always speaks very carefully to avoid upsetting the applecart, so his utterance must have been deliberate and must have had a motivation.
Here are four theories going around Wall Street for why the Fed chairman said what he said:
According to Fed observers, Mr. Bernanke has a consensual style of management on the all-important Fed committee that sets monetary policy. Some members have deep reservations about the large bond purchases. Mr. Bernanke doesn’t agree with the hawks, but he wants them to feel that their concerns are listened to. So he makes an utterance that proves to them that he’s not afraid to publicly envision a definite end to the stimulus. They then feel comforted that Helicopter Ben will have the resolve to stop the money drop â€" one day. This theory is great for the camp that thinks the Fed must keep pressing the gas. It means Mr. Bernanke was merely being a shrewd manager and isn’t going to turn stingy any time soon.
The Fed has a frighteningly poor record of spotting bubbles and deflating them before they become destructive. There is no gigantic, overarching bubble right now that could harm the wider economy. But over the last two years, as the Fed has pumped money into the financial system, large markets have been driven higher by significant amounts of speculation. A Fed governor, Jeremy C. Stein, has highlighted the risks in some of them. On Wall Street, with interest rates this low for so long, it has become easy to make bets with borrowed money. But such investments can unwind violently with even the slightest tightening of credit. Mr. Bernanke may have wanted to throw a little bit of sand into this giant leverage machine. If so, it seems to have worked so far, because some of the frothiest markets have tumbled since his testimony. From the Fed’s perspective, the risk is that the sell-off builds on itself and weighs on the wider ecnomy.
One day the Fed will clearly state that it truly is going to pare back its purchases. That could usher in a turbulent period in the markets. Talking about such withdrawal today could soften any shock it inflicts on the market when it happens. It’s the same reason parents prepare children for their first day of school during the summer. “You could see this as a trial balloon that was floated,†said Brian Smith, who trades bonds at TCW, an asset management firm. “Bernanke might have wanted to see if the market could handle a tapering.†The Fed also gets to examine exactly how the markets reacted and can make tailored responses. In recent weeks, some important assets have been acting in weirdly interconnected ways (just Google the term “convexity vortexâ€). The Fed is now wiser about those sorts of moves.
The final theory is that Mr. Bernanke has in fact shifted his stance. While certainly not a hawk, he has intellectually moved closer to ending the asset purchases than people might realize. It’s important to remember that the latest open-ended program was conceived at the end of last year, when there was great trepidation about the drag that fiscal retrenchment would have on the economy. “Back in December, the Fed didn’t know if we would fall off the fiscal cliff, said David Rosenberg, chief economist at Gluskin Sheff & Associates. “So it may have thought, ‘We’ll shoot now and think later.’ †It turns out that, in spite of Washington’s budget battles, the economy has been quite resilient. For the economic conditions that exist right now, smaller purchases might be more appropriate. Some economists dispute this line of thinking. For instance, they say the Fed isn’t going to taper when inflation rate is declining like it is right now. But Mr. Bernanke may think that dip is temporary, paricularly since some forward-looking indicators in the markets predict a rise in inflation. And some economists see strong signs that the latest round of bond purchases is having its desired effect and will lead to a stronger economy as early as the second half of this year.
When faced with frantic speculation over its motives, and weakening markets, the Fed might be tempted to say things to calm everyone down. So far, the most influential Fed governors have not come out to somehow correct people’s interpretations of Mr. Bernanke’s remarks. That could work to the good of everyone.
“Although the last three weeks have been jarring to everyone - including the Fed - its prime directive is to get policy correct, not worry about several weeks of increased market volatility,†said Jim Vogel, a debt markets strategist for FTN Financial.
