Markets go from nightmare to bad dream

US Treasury

Ben Bernanke sits for the unveiling of the new $100 note, Apr. 21, 2010.

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If you can keep your head when all about you are losing theirs, then you probably haven't been following global financial markets over the past few weeks.

The dizzying price gyrations--across asset classes and indifferent to national borders--might be taken as evidence that the market has lost its mooring to fundamentals.

In fact, a relatively simple story line runs through recent events. The problem for policy makers, importantly including Fed Chairman Ben S. Bernanke, is that this narrative is consistent with two starkly different paths for the global economy going forward.

The story begins with the sorry spectacle of the debate on the U.S. debt ceiling. As has been generally understood and underscored by Standard & Poor's downgrade of the U.S.'s AAA credit rating, elected officials were willing to push the federal government to the brink of default. This was startling proof of deep dysfunction in the political process.

But the surprise was not just the intransigence of a splinter sect of the Republican Party. The Obama administration convinced everyone that it would not, or could not, take unprecedented actions to stave off default if Congress failed to act. Until then, market participants had a touching faith in the willingness and ability of the president or secretary of the Treasury to pull some rabbit out of their hat to protect us from the ill effects of congressional malfeasance, whether possibly by invoking the 14th Amendment or by monetizing gold. The realization that there is no rabbit means coming confrontations on the public debt limit will be more charged and will have a bigger effect on the stock market.

"Once President Barack Obama signed the increase in the debt ceiling, all these realizations hit at once." -- Vincent Reinhart

Attention Diverted

Of more immediate relevance, the brawl on the Washington Mall diverted the attention of financial-market observers for about three weeks. The unread news over that period called into question the underpinnings of sustained expansion in the advanced economies. European officials remained in their patch- and-plaster mode even as confidence deteriorated about sovereign-debt funds and banks on the Continent. U.S. data on spending, confidence and job creation were at best sub-par. And revisions to output over the past few years portrayed an economy that had suffered a deeper recession and was now following a shallower trajectory than previously understood.

Once President Barack Obama signed the increase in the debt ceiling, all these realizations hit at once. Investors floundered for a time in a rougher sea than they had expected, so market prices were scarily volatile. On net, equity prices are now off 11 percent from their July peak on the downward revision to the outlook and the renewed sense that there is greater risk in financial markets.

The key to understanding the outlook and the possibilities for policy lies in analyzing this destruction in wealth to apportion the relative contributions of a lessened prospect for growth and a heightened aversion to risk.

The bad news for Bernanke is that if the net driver of financial market prices has been a downward revision to fundamentals, then the scope for any monetary policy offset is limited. Interest rates are already at rock-bottom levels. Promises to keep the policy interest rate lower for longer will probably not subtract much from them. Indeed, at its last meeting, the Fed tried to work that fallow field a bit more intensely by defining its extended period of accommodation to encompass at least the middle of 2013.

Glum Outlook

Unfortunately, in the process, the statement also signaled that the Fed's outlook was sufficiently glum that it could easily hold its policy rate at zero for that long, reinforcing investors' sense of angst. In such an environment, large-scale asset purchases by the Fed might send Treasury yields even lower, effectively squeezing pips till they squeak, but whether private rates would follow is suspect.

If, in contrast, the main meme in markets is avoidance of risk, then monetary policy might get more traction. Quantitative easing is all about taking riskless Treasury securities off the hands of investors in the hope that those investors will reinvest their proceeds into riskier assets. Such a nudge to risk-taking would move prices significantly, as long as they are not anchored by firm conviction. But this scenario has little to do with rates, which are already low and expected to stay so, and more to do with reducing the quantity of Treasury bonds in the hands of the public.

The best path would hedge against both the possibilities of sub-par expansion and the heightened aversion to risk. The Fed should explain that it will keep policy accommodative as long as its forecast for economic growth falls short of its objectives. Both elements of that determination--its assessment of the near-term forecast and longer-term trends--are released four times a year in the Fed's summary economic projection.

Importantly, linking the policy stance to the outlook allows investors to read a path for policy into the future, filtered through their own economic views. This is better than investors making an uncertain inference about the Fed's forecast based on an unconditional promise to keep rates low.

Accommodation should be read generously to include keeping the policy rate at zero and buying assets. Purchases of Treasury securities could nudge investors toward accepting more risk and so encourage economic growth.

Vincent R. Reinhart is a resident scholar at AEI.

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