Chairman Ben Bernanke’s press conference this week, commenting on the decision by the Federal Open Market Committee (FOMC) not to “taper,” reminded us of the famous slogan of Presidential hopeful George H.W. Bush at the 1988 Republican National Convention “Read my lips: no new taxes.” Yet, after he won the election, he raised taxes in an effort to reduce the public deficit.
Only time will tell whether Bernanke’s comments will meet a similar fate. Our guess is that the Fed might not have to move before early 2014 in the face of anemic economic conditions and lofty unemployment. The looming fiscal debacle, including a possible shutdown of the federal government from a failure to raise the debt ceiling, might have been another factor weighing heavily on the OFMC’s decision to hold the line.
It is also plausible that Chairman Bernanke still believes that the Federal Reserve can talk long-term interest rates down in an effort to help capital spending and housing. However, as previous episodes of quantitative easing (QE) have shown, there is little effect beyond a temporary, spasm-like reaction. Ironically, judging by the steep rise in yields following Bernanke’s passing comment on tapering last May, it seems that it is a lot easier for the Fed to “talk” rates up than pushing them down through the massive buying spree of QE.
And it is not unreasonable to speculate that the Fed’s decision reflects a desire to preserve the Chairman’s legacy. With only a few months remaining at the helm and an imminent Presidential announcement of a successor, why not go out on a cloud of glory as the savior of the world economy and let someone else with more time deal with the potentially messy consequences of unwinding the Fed’s enormous balance sheet?
That the merciless squeeze of the bond market shorts came as a surprise is also ironic. The heavy betting by talking heads and pundits that tapering will start in September was baseless. It clearly shows that second-guessing the Fed is a fool’s game. Unless faced with a crisis, the Fed has no obligation to spell out a specific timeframe of contemplated actions on monetary policy.
The “surprise” short squeeze is an apt reminder that forward guidance by the central bank should not be the basis for investment decisions. It is an ineffectual policy tool and could lead to risky trades, as many well-known bond market gurus have come to lament. And therein lies the rub. Whereas policy execution depends on historical data, policy guidance, the Fed’s new instrument for announcing its policy intentions, is forward looking, relying on hard to predict economic variables.
Being data-dependent is another danger of the Fed’s market guidance policy. The central bank’s poor record in forecasting the course of the economy notwithstanding, basing policy on frequently revised figures is like building a house on shifting sands. For several months this year, the Fed’s forecasts were calling for an optimistic 3 percent GDP growth. But it chose to rely on a recent spate of weak readings in its decision to hold off on tapering. Again, this is another apt reminder that Fed policy is subject to change without notice.
Fed watching has been a thriving business since the 1970s when market participants were anxiously waiting the weekly release of the money supply numbers. As circumstances changed, the way the Fed conducts monetary policy has also changed. One aspect has remained fairly constant, however, and that is the Fed’s inability to determine the level of long-term interest rates. This is especially true in today’s global financial marketplace and enormous capital flows far in excess of the Fed’s monthly $85 billion purchases of long-dated securities. A good example of this impotence is the formal abandoning of “Operation Twist.” Against this backdrop, the only safe assumption investors can make is to take the Fed at its word that short-term interest rates most likely will be held at near zero for a long time. Would anybody want to hazard a guess as to when short rates will begin to rise?
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Disclaimer: This report was prepared by Dimitri Balatsos of Tesseract Partners and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security or investment products.
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