When Bernanke Plays with the Nerves of the Markets

In saying that he could soon curb his “accommodating” policy, Ben Bernanke has sown doubt in the markets, leading some to wonder when the president of the Fed will pull the monetary rug from under their feet.

Investors around the world always heavily weigh every word of the president of the Federal Reserve. That is even truer since the financial crisis. It will be even more resounding this week, when Ben Bernanke has his press conference on Wednesday. Since the last meeting of the committee for monetary policy, the markets have been gripped by doubt. To what extent and at what pace is the Fed going to put exceptional measures in place in order to maintain short- and long-term interest rates at abnormally low levels? This is a question of $3 trillion. That is the amount that has evaporated in stock markets around the world since May 22, the date when Ben Bernanke caused confusion with a throwaway line in Congress. He said the monetary policy committee could “consider reducing bond purchases within the next few meetings,” until they perceive that “the outlook for the labor market has improved substantially.” Certain investors have deduced that Ben Bernanke is preparing, much like investors, for the end of quantitative easing, which started in September and then accelerated in December.

In buying $85 billion in U.S. government and real estate securitized bonds each month, the Fed maintains a strong downward pressure on the interest rate in the long-term. There are several objectives: push capital toward riskier markets like stock markets, and promote real estate and mortgage refinancing, among others. An equity portfolio and well-valued housing must restore confidence to American consumers and encourage them to buy. Quantitative easing also pushes the dollar down, which helps U.S. exports and promotes employment.

The assessment up to May 22 was quite positive: Wall Street has reeled to historic records in May and housing prices show double digit increases in several major urban areas across the country. But now, many investors fear that many current valuations are artificial. They are extremely nervous that it is a house of cards, ready to fall as soon as Ben Bernanke pulls back the monetary rug from under their feet. If the Fed is ready to reduce its purchase of bonds, won’t it stop entirely, sooner than expected? Namely by 2015, if it does not increase its federal funds rate (which is currently close to zero) more rapidly than anticipated?

Recently, the Fed has tried to be reassuring. It sends messages: if it were to reduce its purchases, this measure could be reversed if necessary. The pace of decline of quantitative easing could be very slow. And anyway there would be a large amount of time (several months) between the end of quantitative easing and higher interest rates. But that hasn’t been sufficient. The study of the contracts of swaps in the Fed funds shows that the markets expect an increase as soon as the end of 2014. The yield on 10-year Treasury bonds was higher last week than it has been in fourteen years. The oldest in the trading rooms begin to recall the bloodshed of 1994, when a rapid rise in interest rates caused severe capital losses.

Why would Ben Bernanke, who cannot ignore the echo that his statements would make, take the risk of disturbing investors? Several hypotheses are going around. The first: The president of the Fed simply wanted to give some pledges to the hawks and calm them down. These are the ones who named him “Helicopter Ben,” a metaphor borrowed from Milton Friedman to caricature one who pours mountains of cash on the economy from his helicopter, fearing the formation of new bubbles.

Second hypothesis: Not only does he understand the hawks, but he thinks they are right, at least in part. This would aim to throw a little sand in the gears of the speculative machine.

Third hypothesis: It was a trial balloon, a small phrase aiming to measure the sensitivity of the markets, in anticipation of the real future announcements of the withdrawal of quantitative easing.

Fourth hypothesis: The Fed is actually readying itself to tighten its policy sooner than anticipated.

In reality, what is most probable is that the work of withdrawing quantitative easing and gradually raising interest rates will fall to the person who will succeed Ben Bernanke, at the end of his second term in January. The markets are also beginning to mull over this subject. To whom will Barack Obama give this sensitive position? They cite the name of Larry Summers, Treasury Secretary for Bill Clinton, whose reputation is working against him: a difficult personality, who would be difficult to cope with given the already imposing ego of the monetary policy committee.

Tim Geithner? Recognized domestically and internationally, the first Treasury Secretary of Barack Obama risks having Senate Republications against him in the confirmation process because of his role in the bailout of the financial sector in 2008. After having torpedoed the nomination of Susan Rice to the State Department, certain conservatives are looking for new prey. In any event, Tim Geithner is said not to be interested.

As a result, the current favorite is Janet Yellen, current vice-president of the Fed. A dove who worries more about employment than inflation. No need to panic in the markets. For now, anyway.