Investors around the world are having trouble digesting the latest message from the Federal Reserve – that an era of extraordinarily easy money may start to wind down as early as this fall.
The Dow Jones Industrial Average was down about 290 points (nearly 2 percent) in mid-day trading Thursday. Stock prices in Europe and Asia were down even more – about 3 percent in Germany and Hong Kong, for example.
Treasury bond prices fell also, pushing the interest rate on 10-year Treasury notes to 2.4 percent. That’s a big jump since mid-May, when that rate was below 2 percent.
Chalk it all up to “taper talk,” the growing realization in financial markets that the Federal Reserve may soon slow the pace of its bond-buying campaign known as “quantitative easing.” The so-called QE effort, coupled with ultra-low short-term interest rates, are twin Fed policies designed to spur economic recovery since the financial crisis of 2008 and 2009.
Together, they have increased the supply of money and credit available to businesses and consumers. The near-zero short-term rates have helped hard-hit banks get back on their feet, while the bond-buying program has put downward pressure on long-term interest rates – including for mortgages.
On the surface, it may seem odd that stock markets are unsettled by something that’s ostensibly good news. Conditions have improved to the point where Fed Chairman Ben Bernanke and his colleagues can actually consider the inevitable – phasing out the stimulus. Fed policymakers say they see the risk of stagnation diminishing and prospects for stable economic growth brightening.
But this “good news” brings challenges. Some investors worry the Fed outlook for the economy too optimistic, and may result in a move to withdraw stimulus before the economy is ready to grow solidly without that support. Second, even if the Chairman Bernanke orchestrates a change with appropriate timing and pace, a shift in central bank policy is never easy. Tightening of monetary policy can be a precursor of recession.
“He is finding that making a smooth exit from his ultra-easy monetary policies may be much more difficult to accomplish than he expected,” economist Ed Yardeni said Thursday in a note to clients of his investment strategy firm.
Bernanke’s message at a Wednesday press conference was in some ways a modest change. He reiterated that a downshift in stimulus will only happen if the economy is improving as the Fed expects. And investors have been speculating for several weeks that a tapering of QE might be on the horizon.
Yet the Fed offered some information Wednesday that was new and unsettling to investors.
Forecasts by members of the Fed’s policymaking committee suggested that the unemployment rate might fall to 6.5 percent as early as some time in 2014. Again, that would be good news for the economy, but it pushes forward the moment when the Fed may start discussing a rise in interest rates.
Policy statements from the central bank have pointed to a jobless rate of 6.5 percent as a milestone that would open the door to a hike in the Fed’s short-term interest rate. But for now at least, most Fed policymakers don’t expect to tighten interest-rate policy until 2015.
Also, Bernanke clarified a possible timetable on the bond-purchase program. He said that the Fed could slow the pace later this year (current purchases are about $85 billion a month in Treasury and mortgage bonds). And he said the Fed might stop adding to its bond portfolio if the unemployment rate falls to 7 percent of the work force – from a current 7.6 percent.
The Dow index fell more than 1 percent Wednesday on Bernanke’s comments.
The continuing damage Thursday signals how important Fed easing has been to the recovery in financial markets – and that some wrenching adjustments could accompany a change in policy.
Clearly, it’s possible that the course of interest rates will be generally upward from here. It’s highly unusual, after all, to have 10-year bonds paying just 2 percent annual interest.
But tepid economic growth means the Fed won’t be eager to let interest rates rise too fast.