With traders second-guessing the economic effects of the Fed's actions, it's a bad marriage Bernanke's transparency can't fix
The word "pharmakon", in Ancient Greek, meant two things: both "poison" and "cure".
The term is still relevant today to anyone who is watching to see whether we'll ever have a real economic recovery. That depends on the Federal Reserve, and the Federal Reserve depends on the markets. So "pharmakon" is what the Federal Reserve is to the markets: for the stock markets, the bond markets, the markets for government-supported mortgages, the Fed is both the poison and the medicine.
The Fed cured them of their ills. It helped pull those markets out of their doldrums in 2009. The central bank was so good at its job that the Fed is now essentially a market participant itself, influencing the prices in all those markets. As noted economic researcher Chris Martenson observed:
"The Fed's [market] activities were designed to directly influence the eagerness of parties to buy stocks and bonds because they know the Fed is there buying right alongside them."
It's not just stocks and bonds. Have you seen the price of your house rise recently? Thank the Fed.
The housing recovery we all take for granted now is based, in part, on the Fed's actions. The Federal Reserve buys $45bn a month of mortgage-backed securities that are guaranteed by two government agencies, Fannie Mae and Freddie Mac. You sign a mortgage with a bank, then the bank turns around and bundles that mortgage with many others into a mortgage-backed security. Then, the mortgage-backed securities are sold to buyers, including banks and, since 2009, the Federal Reserve.
There is nothing that causes banks to write mortgages to be written faster than knowing that they have a guaranteed buyer for the final product. The Federal Reserve is that buyer. As long as the Fed keeps buying mortgages, it provides a thick, comfortable net for the ongoing high-wire act of the housing recovery.
So there's no clear rationale for why the markets reacted so badly to the Federal Reserve's statement – except for one possibility: that investors fear that the Fed will eventually stop buying government bonds and mortgage-backed securities, leaving the bond markets and the mortgage markets to fend for themselves after years of support.
They have a right to worry. The Fed is juggling quite a few jobs. Not only is it balancing the markets, it is also the only institution taking any kind of consistent action to improve the economy. We have an ineffectual Congress and milquetoast corporate CEOs, who are not stepping up to the plate to improve the unemployment situation or investing in America. They're waiting for someone else to come up with ideas and fix the problem of the economy, then, presumably, they will pitch in.
That leaves the Fed to fix everything we want fixed: housing, unemployment and inflation (whether too high or too low).
What almost all Americans want to know is when jobs will be plentiful again, or what hope they may have of seeing their paychecks rise. Those are economic issues, not market issues. Yet, in a bizarre twist, those very concrete results in the economy depend on the Federal Reserve's relationship with the markets.
The Fed fixes most of those things, these days, by using the markets. It sets interest rates low in the hopes that government bonds will be an unprofitable investment, which would push people to buy corporate bonds, which in turn would encourage corporations to invest the extra money. (That, so far, has not worked out so well. It has also punished people who save money in bank accounts, which pay nearly no interest right now). The Fed bought mortgage-backed securities first to allow banks to unload their toxic junk, and now to encourage the housing recovery. The markets need the Fed and they hate that they need the Fed.
It's not just that the markets need the Fed. The Fed also needs the markets. The markets signal confidence, which is the most important product the Federal Reserve is selling. If the markets are buying that confidence, the Fed's job is that much easier. Explaining Wednesday's market scowl at the Fed's actions, for instance, economist Paul Edelstein of IHS Global Insight wrote:
"Markets have learned that the Fed is chronically optimistic and aren't buying the upbeat view."
Like bickering spouses in a long-term marriage, the Fed and the markets know each other too well. But both sides of this relationship are often fickle. The Fed changes its policies, and the market changes its sentiments. Neither can fully trust the other.
This thorny relationship between the markets and the Fed – "I love you! Now go away!" – is becoming more important as the economy continues to eke out a recovery, albeit weak and overhyped. And Wednesday, the Fed said that it expects the economy to strengthen.
It is likely wrong about that. The Federal Reserve is not actually particularly good at predicting what the economy will be like – a point made robustly by Wall Street Journal reporter Jon Hilsenrath at the press conference. Ben Bernanke, the chairman of the Fed, had no choice but to agree with him.
It's significant that high unemployment was in the second line of the Federal Reserve's official release: high up, where it needed the emphasis. During the press conference, Bernanke talked about the problematic labor-force participation rate, which indicates people are dropping out of the job market even as the official rate of unemployment falls.
Predicting the economy is a shot in the dark for anyone, including the Federal Reserve. But it has been incorrectly bullish for too long. For the Fed to know whether to continue buying securities, it wants to see the economy improve. It doesn't know if it will.
"We have no deterministic or fixed plan," Bernanke said Wednesday. At most, he suggested that the Fed would wind down purchases starting later this year, and maybe end them next year. Then again, he said, maybe not; the recovery might not be strong enough. Shrug. Play again, next time.
It actually used to be in Bernanke's interest to be vague – when he was too specific, the markets freaked out and threatened to undo some of the benefits he brought to them – but that ship has sailed. Bernanke has committed himself to transparency, more so than any of his predecessors. He wants to speak plainly.
Unfortunately, he is still hostage to market expectations. That's one central tendency that won't change as long as Bernanke stays in his seat. Ben Bernanke's Federal Reserve: "pharmakon" to the markets.
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