Bernanke was clear; Fed's crystal ball is cloudy

Caroline Baum / Bloomberg News /


NEW YORK —

Shoulda, woulda, coulda. It's been a week since Federal Reserve Chairman Ben Bernanke “surprised” financial markets by telling them exactly what they expected, yet the whining is still going strong.

If only Bernanke had been clearer at his June 19 news conference. He said too much. He said too little. He should have said nothing at all. He was too blunt. Too indecisive. He should have reassured the markets.

Grow up, people. It's time to stop blaming Bernanke for your losses. Either you weren't listening or you heard only what you wanted to hear.

In early May, the Wall Street Journal's Jon Hilsenrath, widely viewed as Bernanke's unofficial spokesman, told us the Fed had begun to map out an exit from its $85 billion-a-month asset purchase program. Then, on May 22, when Bernanke testified to Congress, he provided a time frame: at one of the Fed's “next few meetings.” The stock market had a brief hiccup. Treasury yields continued their climb: a cumulative increase of about 100 basis points for the 10-year note since May 2.

When Bloomberg News surveyed economists on June 4-5, more than three-quarters said they expected the Fed to start tapering quantitative easing in the fourth quarter of this year. Bernanke ratified those expectations last week, even as he stressed that any such action was “in no way predetermined.”

He reiterated the idea of variable QE, introduced at his March 20 news conference: buying fewer bonds if the economy improves, more if it sags. He even introduced a new guidepost: an expected unemployment rate of 7 percent by the time QE winds down a year from now. And once again, Bernanke emphasized that the proposed actions were contingent on progress in meeting employment and inflation objectives.

You can take issue with the Fed's choice of thresholds. You can disagree with the Fed's economic projections. You can even accuse the Fed of being too cavalier about falling inflation. But the one thing you cannot do, in good conscience, is accuse Bernanke of being unclear.

Fed officials were genuinely surprised by the market reaction, with prices of stocks, bonds and commodities plummeting across the globe. In their world, outcomes are supposed to mimic expectations. By clearly communicating the Fed's objectives, policymakers should be able to mold expectations and influence outcomes. The future is now, in other words.

That theory works better in textbooks and econometric models than in the real world. What if the Fed's forecast is wrong? Some traders, with a different set of expectations, are willing to bet that it is. Others want to unwind trades before everyone heads for the exit.

For the equity market, interest rates are just one consideration in pricing shares. The rise in rates can be easily overwhelmed by better earnings as a result of stronger growth. If the Fed's optimistic outlook is correct, stocks should make a complete recovery.

Not so the bond market, where expectations about the overnight rate are the key determinant in setting long-term rates. Whether that rate starts to rise in 2015, as most Fed officials expect, or sooner, the markets are sensing the turn in the cycle.

I do have one issue that I'd like Bernanke to clarify, and it concerns the Fed's long-term forecasts. The Fed thinks an unemployment rate of 5 to 6 percent represents full employment. At the same time, it envisions a neutral funds rate — the rate that keeps the economy growing at its non-inflationary potential in perpetuity — of about 4 percent. Bernanke has told us the Fed plans to keep the funds rate near zero at least until the unemployment rate dips to 6.5 percent (from 7.6 percent currently). Minneapolis Fed President Narayana Kocherlakota, part of the EMT squad dispatched to administer CPR to the markets this week, has proposed a 5.5 percent unemployment threshold.

That means the funds rate will be 400 basis points below the desired level at a time when the U.S. economy is at full employment. From that point on, increases in the funds rate are likely to be “gradual,” Bernanke said.

Something is very wrong with this picture. Maybe policy makers just filled in the neutral funds rate based on historical experience without re-evaluating it. Or perhaps the staff is tweaking its model before attaching a number.

If not — if the Fed really plans to wait for full employment before it starts to lift the funds rate — then Bernanke will need a lot more than clarity to prevent the outcome from being an unmitigated disaster.