One of the more conspicuous ironies of the stock market in recent years is that it tends to go down when the Federal Reserve is forecasting an improved economy. That’s because faster economic growth makes it more likely that the Fed will provide less stimulus, in the form of low interest rates, than it otherwise would.
And ever since late May, the stock market has been stagnant, due in part to fears that the Federal Reserve will begin to “taper” its purchases of mortgage-backed securities and long-term government debt.
Today, Federal Reserve Chairman Ben Bernanke tried to calm the markets, announcing that the Fed would continue its asset purchases at the pace of $85 billion per month, and that it would keep short-term interest rates near zero until the unemployment rate falls at least below 6.5%, or inflation increases significantly above the Fed’s long-term goal of 2%.
At the same time, the Fed’s statement did reflect the central bank’s growing optimism regarding the economy, saying that the “downside risks” for the economy and labor market have “diminished since the fall.” And so even though the central bank announced no changes to its current policy, markets dropped sharply following the Fed statement and subsequent Bernanke press conference.
But one should always keep in mind that boosting the stock market isn’t the Fed’s main priority. All things being equal, lower interest rates will lead to higher asset prices, but stocks performed exceptionally well in the first part of 2013, so the most recent pullback could be the partial result of investors simply seeking a reason to cash in their gains from earlier in the year, rather than a fear of the effects of reduced stimulus.
In addition, there’s a case to be made that markets are overreacting to the prospect of the Fed slowing down the pace of asset purchases, as Bernanke has said it might do later this year and into 2014. But the Fed chair tried to reassure market participants that any change in the bond-purchase program would “be akin to easing off the gas pedal rather than putting on the brake,” and that the Fed is able and willing to adjust its purchases back upward if its forecasts turn out to be too optimistic.
Unfortunately, markets haven’t been hearing this message clearly, and if that continues, it could be a problem. Expectations regarding future interest rates have been rising in a manner that even Bernanke admits can’t be fully explained by an improving economy. And if the market is expecting interest rates that are higher than the Fed intends, that will put a damper on economic growth.
The fact that stock markets fell and bond yields rose following Bernanke’s speech and presser are evidence that, at least for now, the markets aren’t taking today’s reassurances at face value. For whatever reason, there remains a belief that the Fed is going to pull back on stimulus and raise rates before it says it will.
In the end, it’s not the job of the market to do what Ben Bernanke wants. Rather, it’s Ben Bernanke’s job to figure out how to communicate his intentions clearly to the market. It would be unwise to draw any definite judgments about Bernanke’s performance in this area from a few weeks of data. But if these trends continue, the Fed is going to have to adjust its approach, perhaps by stepping even harder on the stimulus gas rather than easing off.