The chairman’s challenge: Bernanke says ‘taper,’ markets hear ‘tighten’

June 18, 2013

For a central bank that likes to tout the importance of clear communication, the Federal Reserve sure knows how to be obtuse when it wants to. Take Bernanke’s testimony before the Joint Economic Committee of Congress last month. His prepared remarks were reliably dovish, emphasizing weakness in the labor market and offering no hint of an imminent end to the current stimulus program, which involves the monthly purchase of $85 billion in assets.

It was during the question and answer session that the real fireworks came. Asked about the prospect for curtailing such bond buys, Bernanke said:

If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings … take a step down in our pace of purchases. If we do that it would not mean that we are automatically aiming towards a complete wind down. Rather we would be looking beyond that to see how the economy evolves and we could either raise or lower our pace of purchases going forward.

Those three little words, “next few meetings,” proved rather costly to global financial markets – about a trillion bucks a word in stock value losses.

Was it a miscalculation or a trial balloon, investors wondered. Rather hawkish comments from normally dovish regional Fed presidents like Eric Rosengren of Boston and John Williams of San Francisco seemed to cement the notion that this was a concerted message. It remains to be seen how Bernanke will navigate the issue at Wednesday’s press conference, one of only four per year.

But why was the market reaction, which also included steep selloffs in Treasuries, emerging markets and corporate bonds, so abrupt? The key was the element of surprise, and perhaps a slight confusion over semantics. The market had been essentially been preparing for a tapering of QE3 in the fourth quarter. By saying “next few meetings,” Bernanke had suddenly put June on the table, even though September or December are much safer bets.


The Fed is also having a hard time convincing investors that a reduction in the pace of bond buys is not a prelude to an imminent tightening cycle that would include actual hikes in official interest rates, which have been at zero since December 2008. There’s a good reason for this – historically, when the Fed shifts direction, it can move rather quickly.

Mike Feroli, resident Fed watcher at JP Morgan, explores the disconnect:

A major source of confusion between the Fed and the market is the nature of tapering of asset purchases. According to Fed policymakers, tapering off of asset purchases would not constitute a tightening of policy, but rather a slowing of the pace at which it is adding to monetary accommodation. Thus, even after monthly purchases are reduced from $85 billion to some smaller amount, the Fed would still be expanding its balance and thus still easing policy.

Tightening of monetary policy, in contrast, would be either a shrinking of the Fed’s balance sheet or an increase in overnight interest rates. Tapering is pushing on the accelerator, just not as hard as before, whereas tightening is pushing on the brakes. If the market follows this logic, there shouldn’t be much to fear from tapering. […]

If the Fed were in the flow effect camp, it would be hard for it to argue that tapering isn’t tightening, as a decreased flow of purchases would lead to upward pressure on interest rates. As it is, since Fed officials subscribe to the stock effect view, a slowing in the pace of asset purchases does not necessarily have to push up interest rates. It is important to note, however, that if the Fed were to taper earlier than expected by the market, then interest rates would rise, even according to the stock theory. In Yellen’s phraseology this would be news that would alter expectations concerning the entire path of the Fed’s asset holdings.

This implies there could be a situation where the Fed has tapered sooner than expected, and so interest rates would rise, even though the Fed is increasing its balance sheet and supposedly adding to accommodation. Clearly this would complicate the Fed’s messaging about the distinction between tapering and tightening. This possibility may be related to the concern of some FOMC members who noted in the recent minutes that ‘investor expectations of the cumulative size of the asset purchases appeared to have increased somewhat.’ In order for tapering not to lead to an increase in interest rates, and thus a tightening of financial conditions, market expectations will need to be fairly well-aligned with the Fed’s outlook for asset purchases.

Still, with inflation well below the central bank’s target, Bernanke and his colleagues have room to keep policy loose.

In addition, new policy thresholds say there will be no rate hikes until the jobless rate, currently at 7.6%, falls to 6.5%, for as long as inflation is forecast to remain below 2.5% in a one- to two-year horizon. This is supposed to anchor market expectations even in the face of reduced bond buys.

Says Thomas Lam, economist at OSK-DMG, via email:

The market’s negative reaction thus far is probably a reflection of the information and guidance vacuum surrounding near-term QE adjustments and eventual policy tightening (balance sheet shrinkage and rate normalization), specifically with regards to the relationship and timing between the two considerations.

Investors are also a bit worried, says Lam, about why the Fed would be pulling back on stimulus with inflation so low – might they be worried about bubbles that the market, too, should be mindful of?

I suspect general market anxieties globally might also be speculating as to why the Fed – in light of having the slimmest balance sheet as a share of GDP (at roughly 20%) compared to the other three major central banks (BoJ at almost 35%, ECB at around 29% and BoE at about 26%) – is actively thinking about balancing and managing QE expectations at this time.

Basically, I don’t think the data dependent emphasis is the only ball the Fed is focusing on when mulling over the pace and extent of asset purchases.

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The Fed has been purchasing Treasury securities and MBS in QE operations on and off again for more than 5 and a half years now. It always amazes me that the narrative in the financial media and even among market participants who should know better is that QE has kept long term interest rates at historic lows and that scaling back of QE or what has come to be known as “Tapering” will lead long term interest rates higher. All one has to do is look at the charts to see that whenever QEs 1, 2, or 3 commenced, long term interest rates shot higher and when these QE operations came to and end long term interest rates fell sharply. Could it be that rightly or wrongly most market participants perceive that Fed QE policy equates with printing money and hence inflationary? If so, the logical thing to do is pull the RISK ON lever and buy equities, commodities and credit while selling the dollar and long term Treasury securities. Of course, the reverse RISK OFF trade goes into effect when QE operations wind down.

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