The Federal Open Market Committee, led by Chairman Ben Bernanke, surprised markets with its recent announcement about its quantitative easing program. Rather than reduce monthly bond purchases from the current $85 billion to perhaps $75 billion, as most market watchers had forecast, the FOMC held fast to the status quo. This, after months of rolling out various Federal Reserve governors to suggest that a reduction in purchasing was imminent. Instead, the Fed said it was unsure that economic growth would be sustained. Such uncertainty persists despite five years of intervention that has almost quintupled the Fed’s portfolio from $800 billion in late 2008 to more than $3.7 trillion today (see chart below). The central bank also lowered its U.S. growth projections for 2013 and 2014, further suggesting that no slowdown in bond buying was in sight.
Indeed, the Fed provided no aEURoeforward guidanceaEUR? on how long the bond purchases would last. That would be aEURoedata dependent,aEUR? Bernanke indicated, which in effect is no hint at all. The unexpected move caused equities to surge, bond yields to plummet and the price of gold to jump more than $50 per ounce. The dollar plunged in world currency markets. Emerging market assets, which had been under pressure since Bernanke admitted in May that the Fed would consider tapering, surged in reaction to continued easy U.S. monetary policy and low interest rates.
Even though the Fed emphasized uncertainty about growth ahead, it may also have been caught off-guard by how far U.S. interest rates have climbed since the chairmanaEUR(TM)s May statement. As the chart below shows, the Treasury 10-year note yield surged from 1.93% in mid-May to 3% on September 5 (solid white line, right scale). The 30-year fixed mortgage rate, which closely tracks the Treasury, rose in yield by more than 100 basis points to over 4.6% in early September (yellow dotted line, left scale). Not wanting to hurt demand for housing, which has been vibrant this year, the Fed appears to have indefinitely postponed action on tapering.
The decision has important implications. First, with the central bank having suddenly reversed a policy it had consistently telegraphed to world markets, its future pronouncements lose credibility. Why trust the FedaEUR(TM)s guidance if it may shift policy on a whim? The news will likely increase market volatility since investors have lost the beacon of Fed guidance.
The second issue is that the Fed may find it even more difficult to spark a future “wealth effect” out of a rise in the stock market. Bernanke has repeatedly justified quantitative easing because of the supposedly positive impact of equity prices in making consumers feel more affluent and encouraging additional spending. Now, however, investors may view an advancing market with suspicion, knowing that the Fed could change policy and reverse price movements. Why get sucked into buying shares if the risk of losing money has increased?
Third, a statement Bernanke made during his news conference suggested that the easy money policy could continue for quite a while. He fears, he said, that a aEURoegovernment shutdown, and even more so a failure to raise the debt limit, could have very serious consequences for the financial markets and for the economy.aEUR? Since many influential Republicans in Congress have vowed to oppose a debt limit increase without corresponding spending cuts, this was not a development the chairman was unaware of in May. And since fiscal gridlock has been a theme in Congress for two years, would the Fed not taper until the fiscal situation was resolved to its satisfaction?
It is important to recall that the decision to continue bond purchases at their current pace came just three days after Lawrence Summers, believed to be President Obama’s first choice to succeed Bernanke at the Fed, pulled his candidacy, fearing tough opposition even from Senate Democrats. Equity markets interpreted the exit of the former Treasury secretary, who has expressed doubts about continuing QE at its current pace, as bullish. With Summers’ withdrawal, Fed Vice Chair Janet Yellen, considered extremely aEURoedovishaEUR? by market observers, is seen as the front-runner for the position. Her elevation, if the president so decides, may prompt yet another rally in bonds and stocks.