Markets go from nightmare to bad dream

US Treasury

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

Article Highlights

  • Obama administration states they can't magically protect us from the effects of congressional mistakes

    Tweet This

  • Large scale asset purchases by the Fed might send the #Treasury yields even lower

    Tweet This

  • Investors should be nudged to reinvest in riskier #assets to improve #economic growth

    Tweet This

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.

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Vincent R.
Reinhart
  • Vincent Reinhart, a former director of the Federal Reserve Board's Division of Monetary Affairs, joined AEI in 2008 after working on domestic and international aspects of U.S. monetary policy at the Fed for more than two decades. He held a number of senior positions in the Divisions of Monetary Affairs and International Finance and served for the last six years of his Federal Reserve career as secretary and economist of the Federal Open Market Committee. Mr. Reinhart worked on topics as varied as economic bubbles and the conduct of monetary policy, auctions of U.S. Treasury securities, alternative strategies for monetary policy, and the efficient communication of monetary policy decisions. At AEI, he has continued his work on all of the above in addition to research on key economic variables before and after adverse global and country-specific shocks, policy mistakes leading to the 2007-09 financial meltdown, and the implementation and impact of quantitative easing.
  • Email: vincent.reinhart@aei.org

What's new on AEI

image Dad and the diploma: The difference fathers make for college graduation
image A better way to finance that college degree
image Fracking for bigger budgets
image Earth Day: Hail fossil fuels, energy of the future
AEI on Facebook
Events Calendar
  • 21
    MON
  • 22
    TUE
  • 23
    WED
  • 24
    THU
  • 25
    FRI
Wednesday, April 23, 2014 | 12:00 p.m. – 1:30 p.m.
Graduation day: How dads’ involvement impacts higher education success

Join a diverse group of panelists — including sociologists, education experts, and students — for a discussion of how public policy and culture can help families lay a firmer foundation for their children’s educational success, and of how the effects of paternal involvement vary by socioeconomic background.

Thursday, April 24, 2014 | 12:00 p.m. – 1:30 p.m.
Getting it right: A better strategy to defeat al Qaeda

This event will coincide with the release of a new report by AEI’s Mary Habeck, which analyzes why current national security policy is failing to stop the advancement of al Qaeda and its affiliates and what the US can do to develop a successful strategy to defeat this enemy.

Friday, April 25, 2014 | 9:15 a.m. – 1:15 p.m.
Obamacare’s rocky start and uncertain future

During this event, experts with many different views on the ACA will offer their predictions for the future.   

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.