Bernanke Leaves Yellen With a Massive Migraine
There can be little doubt that today's Fed announcement is an epic attempt at rhetorical audacity. The message they hope to convey is that they are tightening monetary policy by loosening it. Based on the early market reactions, the trick has seemed to work.
I believe the Fed was forced into this exercise in rabbit pulling because it understands far better than the cheerleaders on Wall Street that the economy, despite the soaring gains in stocks and real estate, remains dependent on continued stimulus. In my opinion the seemingly positive economic signs of the past few months are simply the statistical signature of the QE itself. There is little evidence to suggest that the trends are self-sustainable. But seemingly strong data had made the arguments in favor of continued QE increasingly untenable. As they could no longer stay the course the Fed had to do something. Ultimately they decided to play it both ways.
As far as the headline grabbing taper decision, the Fed's hands were essentially tied by widely held expectations. Perhaps spurred by a desire to initiate the end of QE before he leaves the chairmanship, Ben Bernanke did surprise some by announcing the taper now instead of allowing Janet Yellen to do so in March. The $10 billion reduction has convinced many that the QE program will soon become a thing of the past. At his press conference Bernanke affirmed that he expects QE to be fully wound down by the end of 2014. Look for those forecasts to change rapidly.
Without QE to support the markets, in my opinion, the economy will likely slow significantly and the stock and real estate markets will most likely turn sharply downward. As a result, I expect the Fed will do its utmost to keep the markets convinced that the QE program is in its final chapters. But these "Open Mouth Operations" likely represent the full inventory of the Fed's policy options. I suspect that when the economic data begins to disappoint, the Fed will quickly reverse course and increase the size of its monthly purchases. In fact, today's Fed statement was careful to avoid any commitments to additional tapering in the future. It merely said that further changes in the amount of purchases will be dependent on the data. This means that QE could go in either direction.
But more important than the taper "surprise" was the unusually dovish language in which the Fed decided to wrap its seemingly bitter pill. Today's statement goes significantly farther than any prior communications in assuring that interest policy, its main monetary tool, will remain far more accommodative, for far longer, than anyone previously predicted. In fact, they have now committed themselves to keep rates at zero until "well after" the unemployment rate has fallen below 6.5%. On this score the Fed is not simply moving the goalposts, they are running away with them. With such amorphous language in place the FOMC appears to be hoping that it will never have to face a day of reckoning in which they will be forced to actually raise rates. On that score they are similar to the legislators on Capitol Hill who want to pretend that America will never have to pay down its debt.
Despite the slight decrease in the pace of asset accumulation, I believe that the Fed's balance sheet will continue to swell at a pace that would have shocked Wall Street even a few years ago. As the amount of bonds on their books surpass the $4 trillion threshold, market watchers need to dispel illusions that the Fed has any intention to actually shrink its balance sheet, or even stop its growth. Already fears of such moves have pushed up yields on 10-year Treasuries to multi-year highs. Any actual tightening could push them significantly higher. But we are still seeing much higher leverage than what would be expected in a healthy economy, and as a result, the gains in stocks, bonds and real estate markets are highly susceptible to rate spikes. If yields move much higher I feel that the Fed will have to intervene to bring them back down. In other words, the Fed will find it much harder to exit QE than it was to enter.
As he left the stage from his final press conference, Ben Bernanke should have left a giant bottle of aspirin on the podium for his successor Janet Yellen. She's going to need it.