How many markets are in upheaval right now? The ten year Treasury has gone from 2.18% to 2.44% in less than a day. Gold is down to $1288. Asia had a bad night with the Chinese interbank market going into even more distress than before (that can’t be laid mainly at the Fed’s doorstep but it sure didn’t help). The Nikkei was down 1.7%, which is almost a routine market move, but the Hang Seng also fell 2.9%. All major European stock markets are down over 2%. S&P future are down over 16 points, or roughly 1%.
We’ve pointed to several things that have been troubling about the Fed’s apparent view prior to the FOMC statement yesterday and the Bernanke press conference, which only rattled investors further. First was that the Fed seems to be suffering from a bad case of confirmation bias, in that it seems to be underweighing data that is inconsistent with the idea that the economy is getting better (as in on the path to decent growth, as opposed to a gear or two above stagnation). For instance, even though inflation continues to fall (a sign of weakness) the central bank is taking the view that that’s temporary, and it is also of the view that the sequester isn’t going to impose a meaningful drag.
But that may not matter. Fedwatcher Tim Duy highlights the fact that the Fed has a pattern of being too optimistic about growth, but is likely to stick to its guns on exiting QE when its unemployment thresholds are breached. And the big fail is that the Fed using the headline unemployment rate as one of its main metrics for when to wind down QE means it is choosing to stick its head in the sand as far as the severity of underemployment is concerned. This is the economic version of “peace with honor”.
Frankly, the real issue seems to be that the Fed has gotten itchy about ending QE. Who knows why. It may be 1937 redux, that they’ve gotten impatient with the length of time they’ve been engaged in extraordinary measures. It may be that they can’t face up to the fact that they might have gotten into a Japan-style QE forever (I believe Japan is now on QE 8). They might also worry about political backlash if the Fed balance sheet keeps growing, or that savers and investors are suffering in a low yield environment (more likely they are concerned about depriving banks of easy profits, like real earnings on float or easy yield curve profits). John Plender suggested in the Financial Times that Bernanke may be following the view of a recent Frederic Miskin paper, in which Miskin took the view that the Fed window for a QE exit was closing.
I’ve been musing that the impact of QE might well be asymmetrical, that it did less to goose the economy than the Fed wanted. Its main impact has been to lift asset prices. Some studies have confirmed Richard Koo’s take on a balance sheet recession, that consumers prioritize paying down debt over spending, and so the rise in the stock market and recovery in home prices hasn’t led to as much increase in spending as you’d expect. But as I speculated, while lowering interest rates doesn’t do much to stimulate demand in the real economy, raising rates will slow growth in normal times. And it could do more to choke off the nascent recovery than the Fed has anticipated.
The big problems are the Fed has no idea how to exit and this problem results from the flawed design of QE, of targeting quantities rather than rates. So the one thing Bernanke sort of made clear yesterday is the Fed will make up its mind as the data comes in. That’s not exactly the sort of guidance Mr. Market was looking for. He also raised the growth target and suggested the taper might start as early as September. Freakout! Even though Bernanke had made noises about an exit last month, and the the bond market took badly to that, the failure of Fed minions to offer any reassurance in the meantime was a warning of sorts that not enough people heeded.
To make the lack of clarity even more confusing, the central bank had previously said 6.5% was the unemployment level it was looking for. Whoops, in practice, that means it will start tapering earlier, at 7%. That might have been understood by some careful Fed tea-leaf watchers, but most investors had seen 6.5% as far enough away as to only be clouds on the horizon. With the Fed raising its growth forecast and talking about a possible taper in 2013, suddenly it’s looking very immediate in some quarters.
The communication bolix is producing what it is almost certain that Bernanke did not want right now, a further increase in real yields after a marked rise last month.
Clive Crook at Bloomberg makes a good stab at trying to unpack Bernanke’s “transparent as mud” discussion:
Bernanke triggered the recent rise in long-term bond yields when he said last month that “in the next few meetings, we could take a step down in our pace of purchases.” You could argue that he was merely stating the obvious, but the markets took it as important new information. In itself, that needn’t have been troubling. The problem for the Fed is that investors didn’t interpret it as good news about the economy but as bad news about the Fed’s reliability.
As the economy strengthens, you’d expect long-term interest rates to rise. But the recent rise in bond yields coincided with unexciting jobs data and very low inflation — inconsistent with the “strong economy” story. The implication is that investors thought the Fed was bringing forward its plans not just to taper QE but also, crucially, to start raising short-term interest rates.
Bernanke tried to address this confusion this week. He emphasized for the umpteenth time that the decision on tapering QE is separate from the decision on starting to raise short-term rates. All being well, tapering would probably start later this year, he said, with asset purchases continuing in 2014 until unemployment falls to 7 percent.
Interest rates won’t rise, the Fed has previously said, until unemployment has fallen to 6.5 percent. And, Bernanke added with fresh emphasis, perhaps not even then: These numbers are “thresholds” not “triggers.” So the Fed will merely start thinking about raising interest rates once unemployment falls to 6.5 percent, and might well choose not to act at that point. Oh, and it’s always possible, the chairman told another questioner, that the unemployment threshold for interest rates (and presumably therefore also for QE) will be revised — more likely down than up.
You can see what a crazy place we’ve gotten to be with ZIRP plus QE. Raising short term rates at 6.5% unemployment, when that’s certain to be a gross understatement about how weak the job market really is? What that really signifies is the mistake that Bernanke made during the crisis, and too few have called him out on, was his “75 [basis point] is the new 25” Fed fund rate cuts. 25 used to be sufficient to reassure markets, and 75 was seen as panicked but too quickly became a new normal. I had the dim feeling that the Fed had crossed an event horizon when it dropped the Fed fund rate below 1.5%. Even 1% might have been less confining than where it wound up.
Bill Gross in a Bloomberg interview has a good take on where this is likely to wind up but, but it’s a long way from what Mr. Market and even the Fed seems to believe now:
I think they are missing the influence on inflation that obviously the chairman has considered and perhaps the committee as well. There was a question and Q&A that basically said, Mr. Chairman, if we are down at 1% inflation and it doesn’t rise, then real interest rates are in a quandary to which you have limited flexibility, and he said, I agree completely with the premise of your question. I would think the markets are looking at the 7% unemployment rate and suggesting the tapering will end at that point. I would suggest that yes, he did say 7% in terms of an unemployment target where tapering would end, presumably in 2014, but he also qualified significantly a number of times that inflation has to go back up towards that 2% target and at the moment we are not there. Those who are selling treasuries in anticipation that the Fed will ease out of the market might be disappointed unless we have inflation close to 2%…
I think the Chairman is almost deathly afraid and we have witnessed in speeches going back five or 10 years on the part of the chairman in terms of the helicopter speech and the reference not only to the depression but to the lost decades in Japan. I think he is deathly afraid of deflation. As we meander back and forth around the 1% level, i would suggest that the chairman to the extent that he perhaps has a limited time left in terms of being the Chairman, that he would guide the committee towards not only an unemployment rate which has been emphasized in terms of the Q&A but also towards a higher inflation target, which is really a target. It’s not something in terms of a cap, but the inflation target of 2% and for the next year or two, 2.5% has been specifically delineated in terms of that. It’s a target. Those who think it is a cap and we are 1% below the cap and therefore the Fed doesn’t care about it, I think the chairman told us the Fed does care about it and the closer we get to 2%, the better as far as he’s concerned.
TIPS and gold are continuing to say there’s no inflation in the offing. The big fail in the Fed’s forecast is it’s keen to believe it’s succeeding and continuing low or falling inflation amounts to a repudiation. And if it’s proven wrong on that front, that means spooking the markets and increasing real interest rates now wasn’t just creating some inevitable adjustments a smidge prematurely but a more serious error.
Update 8:30 AM. Krugman (hat tip Scott) is also seeing shades of 1937 in this move, and for similar reasons, that the Fed is choosing to look at the headline unemployment numbers and not at the state of the labor markets:
….the fact is that we are still a very long way from acceptable employment levels. Meanwhile, inflation remains below the Fed’s target. Maybe the Fed believes that the situation will improve — but as everyone points out, the Fed has been consistently over-optimistic since the crisis began. And for now the economy still needs all the help it can get.
How can the Fed help? With short-term rates up against the zero lower bound, mainly through expectations — by conveying the message that it will wait to tighten, that it will let the economy recover and allow inflation to rise before hiking rates. To use my old phrase, it must credibly promise to be irresponsible.
And what it has just done, instead, is signal that it’s still a conventionally minded central bank.
So what if recovery stalls, and inflation expectations fall even further? Can the Fed turn on a dime, and send a credible message that it really isn’t so conventional-minded, after all? It’s hard to believe; having already shown itself inclined to start snatching away the punch bowl before the party even starts, it has arguably already given away the game…
I really hope that the real economy recovers at a pace that makes my fears groundless. But if it doesn’t, I fear that the Fed has just done more damage than it seems to realize.