Markets Have Already Misread the Fed

Over the past few weeks, markets have focused obsessively on the likelihood that the Federal Reserve will soon reduce, or "taper," the rate at which it has been injecting money into the economy. 

My bet is that at 2 p.m. today, markets will learn that they have misread the Fed. Over the past few weeks, they've focused obsessively on the likelihood that the Federal Reserve will soon reduce, or "taper," the rate at which it has been injecting money into the economy. The proximate cause? Fed Chairman Ben Bernanke, responding to a question during his testimony before the Joint Economic Committee of Congress, said:

If we see continued improvement, and we have confidence that that is going to be sustained, in the next few meetings we could take a step down in our pace of purchases.

Here are five reasons why we shouldn't over-interpret this:

1. Prepared testimony trumps off-the-cuff answers, and in his prepared testimony, Bernanke said:

A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.

2. Recall, the Fed has set an inflation target -- it's aiming for personal-consumption-expenditures inflation to be around 2 percent. But core PCE inflation grew was only 1.05 percent over the past year; that is the lowest reading ever since this series began in 1960. Headline PCE inflation is running at 0.7 percent. When you're undershooting your inflation target, it's time to keep the monetary spigots open.

3. Inflation expectations are declining. For instance, the spread between nominal and real yields on 10-year Treasury bonds has declined by half a percentage point since March. Subdued inflation gives the Fed more room to stimulate the economy.

4. The Fed's economic projections will surely reveal that it has downgraded its forecasts for both inflation and gross domestic product growth. The downgrades will be small -- only a few tenths of a point -- but they present a case for easier rather than tighter policy.

5. Compare the Fed's forecasts today with those when they first announced the third round of quantitative easing back in September. At the time, they anticipated that core PCE inflation would run at 1.7 percent to 2.0 percent in 2013, 1.8 percent to 2.0 percent in 2014, and 1.9 percent to 2.0 percent in 2015. Today, it's more likely that those forecasts will be closer to 1.2 percent to 1.4 percent, 1.2 percent to 1.9 percent, and 1.9 percent to 2.0 percent, respectively. The latest forecasts for economic growth are also likely to be weaker than those from September. If the case for QE3 was strong in September, it's stronger today.

Bernanke's goal has to be to try to communicate more clearly just what the Fed intends. I suspect that means signalling that the taper is likely quite some time away, and that it will be a function of incoming data, not some preset schedule. If he's successful, then we'll learn that the past few weeks of financial turmoil have been much ado about nothing.

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