How the Fed Blew It
In the future, the Fed will have a much tougher job convincing the markets that it means what it says.
As readers of this column know, I have enthusiastically supported the policies of Federal Reserve chairman Ben Bernanke since the Lehman Brothers bankruptcy five years ago. So I’m certain that most people believe that a stock market bull like me would be enthusiastic about the Fed’s decision to delay tapering its bond-purchase program. But I believe that Bernanke and the Fed have made a serious error.
By adopting a policy that was well outside the expectations of virtually every market watcher, the Fed damaged its most valuable asset: credibility. In the future, the Fed will have a much tougher job convincing the markets that it means what it says. That, in turn, reduces the impact of “forward guidance,” one of the Fed’s most useful monetary tools.
Forward guidance allows the central bank to influence key economic variables, such as stock prices and long-term interest rates, simply by stating what its future policy will be. For example, if the central bank wants to restrain the economy, it telegraphs that there is a heightened probability of a future tightening move, such as an increase in short-term interest rates. The impact of those words alone may prompt an increase in long-term rates. That may be sufficient to reduce the size of any move by the Fed to bump up short-term rates—or possibly eliminate the need entirely.
It’s true that Bernanke never promised that the Fed would begin tapering later this year. But he must have been aware of the market’s overwhelming expectation that the Fed would announce a move in that direction. If he harbored doubts that the Fed should begin a tapering policy, it was incumbent on him to alter the market’s expectations by signaling that doubt in speeches, public testimony or other communications before the Fed’s September meeting.
To be sure, economic data had been on the weak side since the Fed’s previous meeting in July. But the figures were not so weak to justify the Fed thwarting market expectations so thoroughly. If Bernanke wanted to err on the side of caution, he could have eased up on bond purchases by $10 billion instead of $20 billion, as expected by the market. Or he could have reduced purchases of Treasury securities but not mortgage-backed securities, or given guidance that further tapering would be halted if economic activity did not pick up. Any one of those actions would have been in line with the low end of market forecasts, maintained Fed credibility, and given a boost to both stocks and bonds.
A tougher challenge. Now, however, it will be more difficult for the Fed’s words to move markets. Analysts and investors are likely to react to any of Bernanke’s warnings with a “show me” attitude. As a result, the Fed will have to use more aggressive policy tools—such as lowering or raising reserve requirements, which makes it easier or more difficult for banks to lend. Those policy options are more disruptive and generate more uncertainty than using forward guidance to set market expectations.
I can understand that Bernanke might have believed that the market overreacted last spring when the Fed first announced its intention to begin easing up on bond purchases. But to do nothing is not the solution. It merely hurts the Fed’s credibility.
The Fed’s mistake is not fatal. In fact, some people may view Bernanke’s decision as prescient, given the subsequent government shutdown and budget squabbles in D.C. But with a new chairman in the wings, it’s critical to maintain market confidence in the Fed’s word. It has been said that reputation is more important than money. For the institution that prints our money, those words are particularly apt.