Sensible Perspectives

Update on Market Reaction to Evolving Federal Reserve Policy

Posted by on June 25, 2013

Last Wednesday, June 19, Ben Bernanke, Chairman of the US Federal Reserve Bank, held a news conference to discuss evolving Federal Reserve policy. I will not try to reproduce the precise language of the FOMC‘s statement, nor to parse or interpret it (the FOMC or Federal Open Market Committee is the Federal Reserve Board entity in charge of monetary policy).

In general, however, the Chairman made two points:

  1. There is evidence that the US economy is recovering: economic growth is continuing, unemployment is declining, and so on.
  2. As a result, the FOMC anticipates that it may reduce and then stop its extraordinary purchases of US Treasury bonds and US agency mortgage-backed securities sometime next year.

Item 1 is good news – the FOMC follows the US economy very carefully, so its favorable assessment is well worth hearing and heeding.

The recent behavior of stock and bond markets, however, suggests that investors are taking a very different view, at least of item 2. Since Wednesday, the US stock market has declined approximately 6%, and the Barclays US Aggregate Bond index has declined by over 2%, as the interest rate on the 10 year US Treasury bond (which many identify as a key indicator) increased from 2.35% to 2.6%.

To place the stock market decline in context, both the US and global stock market indices have still increased in price since the beginning of the year.
If we can trace the market response to the FOMC’s comments (and most commentators seem to be doing that), I believe it is important to note that the FOMC hasn’t done anything yet. There has been no change in FOMC policy. The FOMC has always been clear that it does not intend to continue extraordinary bond purchases forever. If there is any news, it is the identification of a possible end date for those purchases.

Investors’ responses, as expressed in security price declines and market volatility, can only reflect uncertainty about the investment implications of the policy developments. The bond purchases have not even slowed, and most likely will continue at their current pace for some months yet. So, investors are effectively speculating about the impact in two or three years of a policy change that will start to occur in the next six to twelve months.

The FOMC would not have made this announcement if Committee members did not have considerable confidence in the ability of the economy to operate without extraordinary FOMC bond purchases. (In short, the FOMC appears to have more confidence than investors do!).

It is worth noting that the FOMC is making a concerted effort to be transparent about its policies and policy changes. This reflects a view among macro and monetary economists that clear communication about policy limits market uncertainty and over-reaction. In the absence of this communication, the market volatility might well have been larger.

There are still more policy changes to come before monetary policy returns to a more normal state. Extraordinary purchases of bonds must come to an end. The Federal Reserve must unwind its very large bond holdings. The Federal Funds interest rate must return to normal levels. All of this is to say that there is more volatility coming. And, further difficulties in Europe, Japan or China as each works through their own significant financial issues could produce additional volatility.

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