Professor Bernanke Meets Mr. Market

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Federal Reserve Chairman Ben Bernanke will get a chance at damage control at his news conference on Wednesday, after a two-day meeting of the central bank's policy committee. No doubt he will try to help financial markets understand that "tapering" isn't "tightening," a nuance that seems to have gotten lost somewhere between the March 20 press conference, where he talked about varying the pace of quantitative easing, and his May 22 congressional testimony, where markets heard the end of QE.

And it didn't stop there. Interest rate futures contracts took it a step further, inferring a rise in the overnight rate -- as early as next year -- from the talk about reducing QE.

Interest rates futures point to rising rates, possibly as early as next year. Source: Bloomberg

Given the gyrations in global stock and bond markets this past month, many analysts expect Bernanke to err on the side of dovishness. It isn't hard to understand why. Even if he weren't interested in preventing markets from getting too far ahead of the Fed, the entire premise for QE, as outlined by Bernanke, argues for continued stimulus. Inflation is falling, as are inflation expectations, and the labor market is muddling along. Bernanke is quick to reiterate the costs of long-term unemployment and underemployment, on both the affected individuals and the economy's productive capacity. The only fundamental reason for the Fed to taper QE at this point, using its own parameters, is the realization that exiting isn't going to be an orderly affair.

Federal Reserve's five-year forward breakeven inflation rate. Source: Bloomberg

It was supposed to be so easy -- at least in the textbook version. By guiding expectations about the path of interest rates, the Fed could manage their eventual rise. By articulating both the Fed's goals and the means for achieving them, Bernanke, a former Princeton professor, wanted to apply rational expectations theory to the art of monetary policy.

Until recently, things were going swimmingly. With the help of the Fed's forward guidance, starting with a date for a likely rate increase and evolving to a set of thresholds, short- and long-term rates remained near historic lows. Some of the hawks on the Fed's policy committee have wanted to end this third round of long-term asset purchases, almost from the beginning. But Bernanke seemed to suggest otherwise.

When Mr. Market caught a change in tone, he started to rebel. And you can see his point, too. Each day brings us closer to the eventual end of QE. Even if the federal funds rate stays near zero for several more years, a 10-year Treasury note yielding 2.13 percent today may make no sense if it's headed to 5 percent. Bernanke will try to reassure markets and talk yields down this week, but I suspect investors are looking toward the future. Professor Bernanke has met his match in Mr. Market.

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