So it was, after all, a storm in a teacup. Financial markets around the world have been going through a series of “taper tantrums” since May 21, when Ben Bernanke first mentioned the idea of gradually reducing or “tapering” the Federal Reserve Board’s monetary expansion. Throughout these four months, I have argued in this column that financial markets had grossly exaggerated or completely misunderstood the significance of Bernanke’s comments. This has turned out to be the case, as evidenced by the huge moves in share prices, currencies and bonds on Wednesday after the Fed announced that it would do exactly what Bernanke had suggested all along — namely, nothing.
The Fed’s decision not to cut back on its $85 billion of monthly bond purchases, even by some small symbolic amount such as $5 billion, stunned the markets — but only because analysts had refused to believe what Bernanke, along with most other central bankers around the world, was saying throughout the period since May 21. The Fed chairman repeatedly stated that tapering would begin only if and when there was consistent evidence that U.S. employment conditions were improving. Bernanke also stated that, even after tapering started, the Fed would not allow U.S. monetary conditions to tighten and would keep short-term interest rates near zero for a very long period — at least until 2015, and quite possibly beyond.
Why, then, were investors so surprised when the Fed officially implemented exactly what Bernanke had promised? And now that the Fed has put its money where Bernanke’s mouth was, how will the global economy and financial markets react?
The first question can be answered partly by the sociological forces discussed here back in May. Market expectations are dominated by traders whose job is to speculate on financial volatility and by Fed-watchers who are paid to pontificate on monetary policy shifts. These two powerful vested interests find it hard to justify their incomes by saying that nothing much is going to change in monetary policy for months, or even years, ahead. Another possible answer is even simpler. As noted here after the second “taper tantrum,” when Bernanke tried to clarify his May comments but succeeded only in provoking another wave of bearish speculation, there are times when financial markets make big mistakes — and since 2009 these mistakes have all been on the side of excessive pessimism.
Which brings us to the second, more important, question about the impact of the Fed’s unchanged policies on the world economy and financial markets. The immediate financial response was to bid up stock prices on Wall Street to a new record and boost bond prices, while pushing down the dollar to a seven-month low against the euro and an eight-month low against the British pound. The reaction among economists will probably be to downgrade expectations of U.S. economic growth, in line with the Fed’s new forecasts, which now predict growth of 2 to 2.3 percent this year, instead of the 2.3 to 2.6 percent range published three months ago. Economists in other parts of the world are likely to follow suit, downgrading this year’s expectations more or less in line with the U.S. forecasts.