Ben Bernanke spoke, and bond markets sold off. Then every other market did too. It wasn't that the Fed announced it will do less today -- the dreaded "t-word" -- but rather how and when it will do less tomorrow (assuming, of course, the already weak recovery doesn't get any weaker). But for markets, just describing the beginning of the end of unconventional policies was little different from actually doing so.
With short-term interest rates stuck at zero, the Fed has had to get creative the past five years. Inflation has been too low, and unemployment has been too high, which, in normal times, means the Fed would have been cutting rates. But it can't now. Rates can't go negative or bank depositors would go into cash. But real rates can go negative if the Fed pushes up inflation. That's what the Fed has tried to do with its pair of unconventional policies: forward guidance and quantitative easing. The former means promising to keep short-term rates low in the future, and the latter means buying long-term Treasury and mortgage bonds. The question has been how and when the Fed will go back to normal. Bernanke offered a bit more clarity on Wednesday, and markets didn't like it one bit. Here's how it broke down.
Tapering. Markets have been obsessed with the t-word ever since Bernanke told Congress on May 22nd that the Fed may start slowing its $85 billion of monthly bond purchases in its "next few meetings". Remember, the Fed began this latest round of bond-buying last September, and, unlike previous ones, promised not to stop until labor markets improved "substantially". But what's substantial? Well, as Bernanke said on Wednesday, that's in the eye of the beholder, and in the Fed's eye it means unemployment of around 7 percent. If the economy grows like the Fed expects it to, Bernanke said they will likely start scaling back purchases later this year, and then gradually scale them back further until the purchases stop in mid-2014.
Interest rates. Last December, the Fed announced the so-called Evans rule: the Fed wouldn't raise rates from zero before unemployment fell to 6.5 percent or inflation rose to 2.5 percent. But, as Bernanke takes pains to point out, this is a threshold, not a trigger. In other words, the Fed won't necessarily raise rates when unemployment gets down to 6.5 percent; it just won't do so beforehand. Indeed, the Fed expects unemployment to hit 6.5 percent in late 2014, but 14 of 19 Fed members don't expect the first rate hike until 2015 -- and maybe the end of 2015, as Bernanke suggested.
Why are markets freaking out? After all, the Fed didn't announce any immediate policy changes: it's still buying $85 billion of bonds a month, and it still doesn't expect to raise rates for a looong time. But markets are forward-looking, and the Fed surprised them with how hawkish it says it will be in the future. Indeed, as Paul Krugman points out, when stocks go down, bonds go down, and the dollar goes up -- as is happening now -- it's a sign that investors are scared of a tougher Fed. Here's what's scaring them.
1. A more optimistic Fed. At the beginning of the week, Fed-whisperer Jon Hilsenrath of the Wall Street Journal said to pay close attention to the Fed's economic forecasts: if they maintained their outlook for the rest of the year, it would be a sign they were ready to start tapering by the end of the year. Well, the Fed actually revised up its growth forecast, and said that "downside risks ... have diminished since the fall." In other words, the taper is coming sooner than some had hoped.