The old metaphor for what a central banker does is to "take the punch bowl away just as the party is getting started." That means once economic growth starts to take off, the central bank raises interest rates to prevent excessive inflation.
The United States has been the home of an awfully desolate economic party for five years running, and the Federal Reserve has tried to get things going by bringing in not only the biggest punch bowl ever seen, but a full bar, a rockin' band and maybe a few narcotics of questionable legality. The lesson out of Chairman Ben Bernanke's news conference Wednesday, and the resulting market reaction, is this: Taking all those party enhancements away will be a very hairy experience.
Financial markets have become accustomed to the gusher of dollars -- $85 billion a month -- spewing from the New York Fed in Lower Manhattan and its amazing power to push up the prices of assets across the globe.
That's why even the subtlest hints about when the central bank will wind down those purchases have sent markets into ferocious ups and downs, even undermining some of the success that quantitative easing policies have had at righting the U.S. economy. Stocks were plunging the morning after Bernanke's news conference, with the Dow Jones average dropping more than 240 points, or 1.6 percent, and the Standard & Poor's down 1.7 percent a little after 11 a.m. (We're all hoping that the housing market is now strong enough to survive higher mortgage rates, but we don't really know for sure).
The Fed, it is often argued, has introduced great uncertainty into the marketplace.
Against that backdrop, it appears that on Wednesday afternoon Bernanke made it his to offer whatever semblance of predictability he could offer while taking reporters' questions. Here is the future of Fed policy in a nutshell, drawn from the Fed chief's remarks.
1) We're going to keep printing money at the same rate for now -- $85 billion a month in bond purchases, you betcha.
2) But if the economy keeps growing steadily, which we think it will (see projections!), we'll start reducing that pace later this year. When exactly? Well, we'll see.
3) Then, we'll gradually cut back on the purchases and then stop them when the unemployment hits 7 percent or so, which we expect to be around the middle of 2014. Again, though, that assumes the economy keeps growing the way we expect it to! If we're wrong, we'll change our strategy, we promise!
4) But just because we aren't buying new bonds anymore, that doesn't mean we're going to be tightening the money supply! In fact, it will probably be a good deal longer before we think about raising short-term interest rates -- for example, when the unemployment rate has fallen to 6.5 percent, or quite possibly even lower. Probably the second half of 2015!
5) And even once the day comes when we're tightening the money supply, we're not going to be rash about selling off the $3 trillion-or-so in bonds we've bought these last few years. Wouldn't want to spook markets and whatnot. So we'll probably just hold onto those bonds for a good ole while, until they mature. Meanwhile, we'll use other tools to contract the money supply, namely raising the interest rate we pay banks to park their money here at the Fed.
6) So, really, folks, stop your fretting over what will happen as we start to exit the bond market. This may hurt a bit, but we're going to move gradually enough that it shouldn't cause some huge sell-off. The most important thing is that we're only going to proceed with the exit if our projections of solid economic growth come true. It's a road map, yes, but one with a lot of off-ramps. If we get to next summer and there's a new euro zone crisis or a Chinese recession that sucks the wind out of U.S. growth, we'll slow down with these plans.
The path described above pretty much fit what I understood to be the consensus view in markets of the Fed policy going forward. That being the case, the sharp sell-off across all types of markets surprised me. In particular, rates on Treasury bonds spiked as investors sold off the securities; 10-year Treasuries yielded 2.38 percent Thursday morning, continuing a rapid rise from 1.63 percent at the start of May. One factor in the run-up in rates -- which if it goes too high could endanger the budding housing recovery --seems to have been Bernanke's comment that the rate increase thus far was likely driven by an improving economic outlook and thus wasn't causing tremors at the Fed. That can be taken to mean that the central bank probably isn't going to extend its QE policies further just because long-term interest rates rise.
But the basic challenge the Fed is facing, and the core reason for the sell-off on markets since Wednesday afternoon, is that no matter how much detail the chairman tries to give, in a financial world driven so heavily by central bank activism over the last few years, even the tiniest changes have big implications for asset prices. "Although the path to tightening has been mapped out, the Fed cannot create certainty from uncertainty as much as they try," wrote Deutsche Bank currency strategist Alan Ruskin in a report.
The Fed has been as transparent about its future plans as has any central bank in history. But in a central-bank driven market, the volatility isn't going away.