Bernanke’s calculated retreat

July 15, 2011

Financial markets were caught wrong-footed by what some interpreted as a flip-flop on the part of Federal Reserve Chairman Ben Bernanke. During testimony on Wednesday, Bernanke indicated the Fed was weighing a possible additional round of monetary stimulus. In his own words:

The possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might re-emerge, implying a need for additional policy support.

Investors, frazzled by everything from Europe’s debt to a U.S. battle over the debt ceiling, took this as a greenlight to dive back into stocks and scurry out of the U.S. dollar. But, having gotten Wall Street salivating, the Chairman’s tone on Thursday was not nearly as open-handed.

Given that there is a lot of uncertainty about how the economy will evolve, we have to keep all options, both for tightening and for easing, on the table. Again, we are doing that. But again we are already providing an exceptional amount of accommodation and the recovery is still pretty slow.

But was it really a flip-flop, or a calculated policy move? After all the Chairman, once seen as an academic with little market experience, is no longer a rookie at managing sentiment. And he knows all too well that, once the green light is given for a third round of quantitative easing, or QE3, the markets will rush to price it in.

In this light, Bernanke’s pullback might be seen as a way to whet the market’s appetite without letting it get too full too quickly.

One particular factor makes Bernanke more reluctant to ease this time around: the threat of deflation, which seemed imminent last year when QE2 was launched, has faded into the background. Instead, inflation has been rising, with core consumer prices posting a sharp 0.3 percent gain in June.

Still, looking further down the line, a deteriorating economy could revive the deflation threat, paving the way for another round of bond buys. Indeed, inflation expectations retreated sharply in July, according to a survey published on Friday by Thomson Reuters/University of Michigan. In the end Fed officials might see that measure, rather a potentially  as the real indicator to watch.

JP Morgan’s resident Fed-watcher Michael Feroli argues that that in evaluating its options in a scenario that pairs slightly higher inflation with very high unemployment, the Fed might favor “a vigilance toward any hint of a reemergence of deflationary psychology.”

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