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Markets Misinterpreting Federal Reserve’s Statements

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After Federal Reserve Chairman Ben Bernanke said that the central bank may begin to curb its $85 billion a month asset purchase program by the end of this year, stock markets plunged. Interest rate futures contracts declined and long-term interest rates spiked. It shows how skeptical market sentiments are. Investors also believe that the Federal Reserve may increase short-term interest rates much earlier that economists anticipated.

Markets Misinterpreting Federal Reserve's Statements

However, Jon Hilsenrath of the The Wall Street Journal says that markets have been misreading the central bank’s messages. In fact, he has some solid supportive arguments to back his thesis. Hilsenrath says that the Fed took several steps to let markets know that it won’t hurt the U.S. economic recovery.

Jon Hilsenrath’s Analysis of Federal Reserve’s Statements

First, Ben Bernanke stated that the central bank may start pulling back the asset purchase program by the end of this year. But he also clearly said that the central bank would not raise the short-term interest rates anytime soon, which would be a more aggressive step. And even when the time to increase short-term interest rates comes, it will be gradual. It shows how cautious the Federal Reserve is being, although Bernanke hasn’t shown that caution before.

Moreover, he said that the Fed may keep short-term interest rates near zero for longer than the central bank had previously planned. The Fed has emphasized that short-term interest rates will remain near zero until the unemployment rate falls below 6.5 percent. Mr. Bernanke said rates could remain low for some time even if the jobless rate falls below 6.5 percent, if inflation is low. During the question and answer session, he went one step further to say that the central bank may even consider lowering that 6.5 percent threshold.

Another important thing to note is that 15 central bank officials think the Fed doesn’t need to increase short term rates until 2015 or 2016, compared to just four who favor raising it before then. Hilsenrath’s next point is that a “strong majority” of Fed officials are against selling the Fed’s portfolio of mortgage-backed securities. The Fed said its MBS portfolio will shrink as mortgages are paid off. In the past, the central bank has indicated the possibility of selling these bonds someday, which would have been a real threat to anybody holding the bonds.

A hawk turned dovish. James Bullard, chief of the St. Louis Fed, said in a statement that the Federal Reserve should make policies even easier. In the past, Bullard has openly opposed easing monetary policies.

The Fed made all these efforts to assure the markets that it wouldn’t apply the brakes anytime soon. But investors reacted sensitively to the Fed’s statement of pulling back its stimulus. Hilsenrath says even that statement was conditional. The Fed said at FOMC that it will reduce the asset purchase program only if the economy continues to improve on expected lines.

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