The S&P 500 closed lower on Friday, capping off another shaky week for stock markets, which have pulled back of late after a torrid start to the year. Though weak consumer-confidence data likely contributed to Friday’s declines, many market observers are blaming the recent weakness in the stock market on fears that the Federal Reserve will begin to taper its bond-buying program as soon as this week.
The evidence for this point of view is pretty strong. On May 22, in a briefing to Congress, Federal Reserve Chairman Ben Bernanke said that the central bank could possibly begin to downsize its $85 billion per month bond-buying program “in the next few meetings,” if the economy sees enough improvement and it looks sustainable. And since that time the S&P 500 has fallen 1.7%.
As Ed Yardeni, president of Yardeni Research, wrote in a research note:
“The recent decline in bullish sentiment mostly reflects investors’ confusion and uncertainty about the monetary policies of the major central banks … The fear is that the monetary authorities will start cutting back on the high-octane liquidity they have been adding to the financial markets’ punch bowl.”
But markets are prone to overreaction, especially during times of economic uncertainty. What Bernanke said in May was really just a reiteration of his explicit promise not to raise short-term interest rates at least until the unemployment rate falls to 6.5%, and not begin to reduce its buying of long-term bonds until “the outlook for the labor market has improved substantially.”
The problem is that this latter promise is extremely vague. Nobody knows exactly what the labor market improving substantially means, and given the fact that the members of the Federal Open Market Committee themselves are in disagreement over what the appropriate policy is, the market is right to be confused over what exactly future central-bank policy will look like.
While it would be preferable if the Federal Reserve were more of one mind regarding policy, part of the recent volatility in the markets seems to stem from a misunderstanding of avowed policy. Sure, Bernanke may begin to taper the purchase of long-term Treasury and mortgage debt, but it would appear that market participants are conflating this possibility with the idea that the Fed will soon raise short-term interest rates too.
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The reason why the market is expecting higher rates in the short term isn’t exactly clear. A rapidly improving economy will surely lead to the Fed raising rates sooner than they now say they will, but there’s not a ton of evidence to support the idea that the economy is recovering faster than the central bank expects.
One of the things Bernanke’s tenure as Fed chair will be remembered for is his effort to communicate more to the public. His periodic release of minutes to Fed meetings and regular press conferences are just two examples of this stepped-up effort. But Bernanke isn’t doing this simply to increase transparency. It’s also an effort to increase the effectiveness of monetary policy by influencing people’s opinion of what future monetary policy will be. Convincing the public that rates will remain low for five years is much more effective than simply causing rates to be low right now.
As the past several weeks show, however, Bernanke is failing to make full use of this aspect of monetary policy. It’s partially a result of dissent inside the Fed and partially a result of the market misinterpreting what the Fed is saying. Either way, what we have here is a failure to communicate, and Bernanke will have to work this week, and during Wednesday’s scheduled press conference, to reverse that failure.