Why Bernanke’s clearer message landed with a thud

Posted Friday, Jun. 21, 2013  comments  Print Reprints
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Wall Street investors wanted clarity from Federal Reserve Chairman Ben Bernanke.

They didn’t like it when they got it.

Bernanke set the record straight Wednesday about the Fed’s bond-buying program. He said the Fed expects to scale back bond purchases later this year and end them entirely by mid-2014 if the economy continues to improve.

In response, investors dumped stocks and bonds in anticipation of rising interest rates. The Dow Jones industrial average plunged 353 points on Thursday, its biggest one-day decline since November 2011.

So why did Bernanke’s remarks spook the markets?

The Fed has been buying $85 billion worth of Treasury and mortgage bonds a month since late last year. The purchases pushed long-term rates to historic lows, fueled a record-breaking stock market rally, encouraged consumers and businesses to borrow and spend, and provided a crutch to an economy hobbled by federal tax hikes and spending cuts.

Confusion about the central bank’s intentions set in last month when the Fed released a summary of its April 30-May 1 meeting: Several Fed policymakers said they were open to reducing the bond purchases as early as this week’s meeting.

Bernanke, meanwhile, told Congress that the economy still needed help, but also that the Fed might decide to cut back the bond purchases within “the next few meetings” – earlier than many had assumed.

The conflicting messages left investors bewildered. Just a hint of a pullback in the bond purchases sent bond prices plunging and their yields soaring.

So on Wednesday Bernanke, a former Princeton University professor, took pains to make the Fed’s intentions as clear as possible.

Going beyond the formal statement released by the Fed’s policy committee after its two-day meeting this week, the chairman told reporters it would “be appropriate” to reduce the monthly bond purchases later this year and to end them by mid-2014 – if the economy performed as well as the Fed expects. He said the bond-buying would probably end when the unemployment rate fell to “the vicinity of 7 percent” from May’s 7.6 percent.

Bernanke explained that the rest of the Fed’s policymaking committee had “deputized” him to expand on what fit “into a terse FOMC statement.”

Plans to reduce the purchases are “very data-dependent, and that’s important,” says Joseph Gagnon, a former Fed official who is now senior fellow at the Peterson International Institute for Economics.

Bernanke likened any pullback in bond purchases to a driver letting up on a gas pedal rather than applying the brakes.

He stressed that even after the Fed ends its bond purchases, it will continue to maintain its vast investment portfolio – which has ballooned to $3.4 trillion – to help keep long-term rates down.

The economists at PNC Financial Services Group said the market sell-off was probably an “overreaction” to Bernanke’s comments. If the Fed scales back its bond purchases, after all, it would mean the economy is strengthening, something that should be good for corporate profits and for stocks.

The Fed faces a tough decision: If the central bank pulls back its stimulus too soon, the U.S. economic recovery could sputter. If it waits too long, superlow rates could ignite inflation. Or they could swell speculative asset bubbles as investors pursue riskier investments with potentially richer returns than low-yielding bonds.

The Fed knows the timing is tricky. It ended an earlier round of bond purchases in June 2011 only to see economic growth remain weak and unemployment stay at levels more consistent with a recession than a healthy recovery.

And if the Fed puts out a confusing message, investors could panic, dump bonds and drive rates high enough to jeopardize economic growth.

“We are determined to be as clear as we can,” Bernanke said at Wednesday’s press conference, “and we hope that you and your listeners and the markets will all be able to follow what we’re saying.”

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