Krugman is right about the market reaction to the Fed’s tapering

Paul Krugman penned a New York Times Op-Ed, “Et Tu, Bernanke?“, referencing the famous Shakespeare quote “Et tu, Brute” which is generally used to signal betrayal from someone unexpected. Krugman meant to say that the Fed has betrayed the American economy by moving away from QE too early. And while I take issue with this framing of the situation, I agree wholeheartedly with how Professor Krugman interprets the market reaction to the Fed’s telegraphing its QE timetable.

As I write this, the 10-year US government bond is yielding 2.60%, whereas it had been 2.18% on June 18th prior to Bernanke’s QE tapering clarification. So clearly, the market reaction to Bernanke’s tapering talk has been negative for interest rates in the US – and globally. The question is why? As a reminder, here’s what I wrote the day after the taper talk.

“None of this is new information. Fed officials have been saying all of this for weeks. Yesterday, the Fed simply reiterated their starting position, adding transparency and clarity. Bernanke told reporters specifically that the Fed’s unemployment target was below 6%, with 7% a guidepost for paring asset purchases and 6.5% as the threshold for considering raising rates. Based on Fed projections that works out to be paring asset purchases by the end of the year, with rate hikes only happening by mid-2015.

“Now, the problem here is in terms of market expectations. As you know by now, non-interest rate monetary policy like quantitative easing works mostly through an expectations and private portfolio balance channel. This means that QE is mostly about telegraphing the Fed’s stance as either more or less accommodative, allowing investors to shift private portfolio preferences as a reaction. What the market heard yesterday was that the Fed is relatively bullish on the US economy. So the Fed will move to a less accommodative stance over time, with a decline in asset purchases preceding gradually through 2014. Tightening via rate hikes won’t occur until at least 2015.

“The market sold off on this news, in what I believe was an overreaction to the Fed policy statement because the market is pricing in a hike of 50-75 bps by mid-2015 when Bernanke said the Fed would first hike rates. According to CME data, the market is putting a 52% probability on a rate hike by December 2014. Clearly, the Fed’s communication strategy is not working because the tapering talk has spooked the market into thinking there is more tightening than there really will be. Witness the remarks from Paul Krugman as indicative of the alarm some have regarding Fed’s timetable for less accommodation.”

My interpretation then is that the Fed simply reiterated what it has been saying for the past month, that it believes the economy is robust enough to withstand a move to end QE. And the market did not like this because it believes that this presages tightening. So long rates have climbed while short rates have sat still. That’s where we are today.

Now, Paul Krugman puts this slightly differently, but I agree with the thrust of his comments. Krugman writes:

Lately, Fed officials have been issuing increasingly strong hints that rather than doing more, they want to do less, that they are eager to start “tapering,” returning to normal monetary policy. The impression that the Fed is tired of trying so hard got even stronger last week, after a news conference in which Mr. Bernanke seemed quite happy to reinforce the message of an imminent reduction in stimulus.

[…]

 Still, it’s just talk, right? Well, yes — but what the Fed says often matters as much as or more than what it does. This is inherent in the relationship between what the Fed more or less directly controls, namely short-term interest rates, and longer-term rates, which reflect expected as well as current short-term rates. Even if the Fed leaves short rates unchanged for now, statements that convince investors that these rates will be going up sooner rather than later will cause long rates to rise. And because long rates are what mainly matter for private spending, this will weaken growth and employment.

Sure enough, rates have shot up since the tapering talk started. Two months ago the benchmark interest rate on 10-year U.S. government bonds was only 1.7 percent, close to a historic low. Since then the rate has risen to 2.4 percent — still low by normal standards, but, as I said, this isn’t a normal economy. Maybe the economic recovery will, as the Fed predicts, continue and strengthen despite that increase in rates. But maybe not, and in any case higher rates will surely mean a slower recovery than we would have had if Fed officials had avoided all that talk of tapering.

Fed officials surely understand all of this. So what do they think they’re doing?

One answer might be that the Fed has quietly come to agree with critics who argue that its easy-money policies are having damaging side-effects, say by increasing the risk of bubbles. But I hope that’s not true, since whatever damage low rates may do is trivial compared with the damage higher rates, and the resulting rise in unemployment, would inflict.

In any case, my guess is that what’s really happening is a bit different: Fed officials are, consciously or not, responding to political pressure. After all, ever since the Fed began its policy of aggressive monetary stimulus, it has faced angry accusations from the right that it is “debasing” the dollar and setting the stage for high inflation — accusations that haven’t been retracted even though the dollar has remained strong and inflation has remained low. It’s hard to avoid the suspicion that Fed officials, worn down by the constant attacks, have been looking for a reason to slacken their efforts, and have seized on slightly better economic news as an excuse.

And maybe they’ll get away with it; maybe the economic recovery will strengthen and all will be well. But rising interest rates make that happy outcome less likely. And now that everyone knows that the Fed is eager to slacken off, it will be hard to get interest rates back down to where they were.

This is spot on. As I wrote after the tapering announcement, “My read here is that the Fed will move to keep inflation around 2% over the medium-term but will work to keep it from falling below 1% in the short-term. On some level, that makes the Fed’s lack of concern about falling inflation and inflation expectations puzzling. But it’s not as puzzling when you consider pieces of the puzzle not associated with the Fed’s formal dual mandate” i.e. the political pressure to remove accommodation, especially given the froth in risk assets like high yield, emerging markets and leveraged loans.

In the narrowest sense, the Fed has a dual mandate to keep inflation within a tight range and to promote full employment. But the Fed is a political organization. And that means it has its ears attuned to how Fed policy impacts the Fed’s stature as an institution. There is a chorus of people like Krugman exhorting the Fed to do more. However, in my view, there are many more people who want to see the Fed do less – witness the NYTimes piece by Roger Lowenstein just this past weekend. And it is that imbalance which tilts the Fed ever so much away from its extremely aggressive monetary policy.

The truth here is that there is no direct transmission mechanism from QE to credit growth since banks are not reserve-constrained. So QE is really about signalling future Fed policy and creating shifts in private portfolio preferences as a result, what we now know as risk-on or risk-off. The Fed, in its quandary on how to finesse the issue of eventually removing policy stimulus, has unintentionally signalled to the world that investors should move to a risk-off position. I do not believe this was the Fed’s intention. However, I also do not believe that Bernanke will swayed by the uptick in bond yields to backtrack on his timetable. Rather, as the timetable becomes clearer, markets will realize that the Fed in fact is more accommodative than they initially realized, and so bond yields will fall again. The question is whether the volatility will do any damage in the markets or the real economy in the interim.   I would say yes, especially since I am on record for expecting a major stock market correction sometime this year. Even so, this only reinforces the notion that yields will fall because market and economic weakness leads to more accommodation as set out by Bernanke’s timetable.

The Fed controls short rates and long rates can only move so far to the upside given the expectations anchor. As time goes on, it will become ever clearer that the Fed is not taking its foot off the accelerator. And so I expect yields to drop again.

UPDATE: 1320 ET – I see Narayana Kocherlakota is confirming my view here via Bloomberg:

The market’s reaction to the Fed’s statement “so far is not a cause for concern,” Kocherlakota said in a phone call with reporters after releasing his statement. If yields continue to stay higher, “that would be restrictive to economic conditions” and suppress both prices and employment.

What he’s saying is effectively, we are more dovish than you think. Clearly we need to communicate this better. The Fed is not concerned about the yield uptick because in due course, it will be clear where the Fed stands. In any event, higher yields will make our guideposts, thresholds and targets harder to achieve, pushing back our timetable.