U.S. Federal Reserve Chairman Ben Bernanke is playing a potentially dangerous game of chicken with global financial markets sent reeling by his threat to scale back the central bank's huge stimulus program.
The Fed chief stood his ground at a news conference on Wednesday, laying out in detail a plan to begin winding down the central bank's $85 billion a month in bond purchases later this year. At the same time, he emphasized the Fed does not see such a move as an outright end to its supportive policy nor would it mark an imminent start to interest rate increases.
Yet global financial markets homed in on the notion that interest rates will probably only go up from here. The response was unequivocal: a massive global selloff in assets of all stripes, especially in risky securities like stocks and corporate bonds. Emerging markets were hit particularly hard.
In the Fed's view, just maintaining its bloated $3.4 trillion balance sheet should provide stimulus to the economy. But in the eyes of the market, losing the single-biggest buyer of U.S. Treasurys means there will be less money to go around.
"The Fed likes to believe according to its simplistic models that tapering isn't tightening, but of course it is," Julia Coronado, chief North America economist at BNP Paribas, said. "A signal from the Fed that it is biased to reduce accommodation signals that the low in rates is behind us. Investors are paid to be ahead of the Fed and will now be selling on rallies instead of buying on dips."
"It is a paradigm shift," Coronado, a former Fed staffer, said.
The question now is how far markets must crater before they harm the U.S. economic recovery enough to force the central bank to reconsider. In laying out a surprisingly detailed plan, Bernanke appears to have set a high bar for a reversal.
Not even safe-haven securities were spared in the selloff. Yields on the benchmark 10-year Treasury note, which move inversely to price, hit 2.47 percent, their highest level since August 2011 and up more than three-quarters of a point since early May.
The rapid rise in the yield, which is a used as a benchmark for mortgage rates, has some economists worried that recent strides in the U.S. housing market might be undone. Mortgage applications have already been falling off as 30-year mortgage rates push toward 4.2 percent. Housing-related shares took a beating on Thursday.
One of the problems with the central bank's message may relate to policymakers' overconfidence in how surgically they can apply their rather blunt monetary tools.
In an effort to keep borrowing costs low, the Fed has promised to leave overnight interest rates near zero at least until the jobless rate, currently at 7.6 percent, falls to 6.5 percent, as long as inflation remains under control.
Economists believe such guidance is one of the most powerful tools central banks can employ given that longer-term rates embody expectations on the path of short-term rates.
But that message does not seem to be sinking in.
MIXED SIGNALS ON GROWTH
So far the housing recovery has remained intact, as evidenced by data on Thursday on existing-home sales for May. Sales rose to an annual rate of 5.18 million units, the highest since November 2009, and selling prices were up 15.4 percent from a year ago.
The gains in housing have helped fuel consumer confidence and underpin spending, but analysts are worried that buyers might be scared away from the newly vibrant market.
In addition, the manufacturing sector is showing signs of fraying and the outlook for government spending is still tight, leaving plenty of clouds over the economic horizon.
Add in risks from overseas that are not insignificant. Chinese manufacturing activity weakened to a nine-month low in June, reinforcing signs of tepid second-quarter growth. European data on Thursday suggested the euro zone would remain in recession for now. Spanish and French funding costs jumped at auction, also because of Bernanke's bond-tapering road map.
The Fed said it would only follow through with its plans if its forecast for the U.S. economy appeared to be coming to fruition. But it appears to be lowering its own bar for success.
By its own estimates, unemployment is likely to remain too high and inflation too low for the foreseeable future. So why are officials so keen to pull the rug out from under the feet of markets?
"What's missed in the market is the big 'if' the economy will respond positively to the stimulus in the second half of the year. And I have serious concerns about that," Bruce Bittles, chief investment strategist at Robert W. Baird, said.
Before this week's Fed meeting, analysts had complained that mixed signals from Bernanke late last month had boosted market volatility. But the chairman's clarity on Wednesday sparked sharp selling, suggesting the real fear is that stimulus will be pulled back before the economy is ready.
Bernanke may have also wanted to lay out an exit plan for bond purchases in advance of potentially stepping down at the end of his term early next year, to wrap up his legacy as chairman and smooth the transition to his successor.
DOVISH MORSELS, DISCARDED FOR NOW
It's not that Bernanke was unequivocally hawkish. After all, even as he fleshed out a timeline for stimulus reduction, he announced an important shift in the Fed's strategy for managing an exit from its extraordinary support for the economy that should have helped sooth concerns in markets.
"A strong majority now expects the (Fed's policy) committee will not sell agency mortgage-backed securities during the process of normalizing monetary policy," Bernanke said.
He also stressed the central bank will be patient in determining when to raise rates after the 6.5 percent unemployment level is reached, saying it wouldn't "automatically" trigger tighter policy and that the threshold could be lowered.
But that prospect seemed too far into the future to matter for a short-term focused market.
"The markets are certainly taking the view that rates are probably headed higher," said Scott Anderson, chief economist for Bank of the West. "The Fed sees taper as a slowing down of the accelerator, rather than a tightening of monetary policy ... a lot of investors want to get ahead of the curve."
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