Federal Reserve Chairman Ben Bernanke sent tremors through U.S. financial markets on Wednesday when he announced that the Fed plans to pull back on its extraordinary efforts to help the economy later this year.
Though Bernanke insisted Fed policy had not changed and said he was merely trying to explain the Fed's thinking process more clearly, traders read his words as a loud-and-clear signal to sell -- illustrating a long-standing communication problem between policymakers and markets.
The Dow Jones Industrial Average ended the day down 206 points, or nearly 1.4 percent, one of its worst sell-offs of the year. Prices on 10-year Treasury notes, which benefit from the Fed's bond-buying stimulus program, tumbled as Bernanke spoke, pushing interest rates -- which move in the opposite direction -- to their highest levels since March 2012, according to data tracker Tradeweb.
At a press conference in Washington, D.C., to discuss the latest policy decision of the Federal Open Market Committee, the central bank's monetary policy arm, Bernanke said the Fed has seen some improvement in the outlook for the economy recently. If the economy keeps getting better, Bernanke said, central bankers might by the end of the year slow the pace of their program to drive interest rates lower and boost the economy through bond purchases. This plan, commonly known as "quantitative easing," or "QE," currently amounts to $85 billion per month in purchases. Bernanke said the Fed would keep slowing bond purchases if economic data keep improving, with a view toward stopping them altogether some time in the middle of 2014.
Bernanke also added that, if the economic numbers don't improve, then the Fed might not taper its bond purchases until later. And if things get worse, then the Fed might buy more bonds. Bernanke also emphasized that even a slower pace of bond buying is still stimulus, and that the Fed has no plans to actually raise its key policy interest rate, currently at zero, until at least 2015.
Nothing Bernanke said varied much from what most market participants should have already expected. Apparently, though, financial markets were hoping for something like an open-ended promise of stimulus from Bernanke -- not exactly a ringing endorsement of the economy's ability to stand on its own two feet.
"Markets have learned that the Fed is chronically optimistic and are not buying the upbeat view," Paul Edelstein, director of financial economics at the research firm IHS Global Insight, wrote in a note. "But then markets shouldn’t worry about the Fed tapering this year, that is, if they believe Bernanke’s contention that the decision is truly data-dependent."
Despite sounding relatively upbeat notes about the economy, the Fed still expects unemployment to be around 7 percent a year from now, down only slightly from 7.6 percent today. It also sees little or no sign of inflation in the economy. That sounds like great news, but the Fed is concerned about the risks of something called "deflation" -- when prices fall and keep falling, making people and businesses delay purchases and bringing economic activity to a halt. That is why the Fed has set a target for inflation growth of 2 percent annually -- a target it expects to miss for most of the next couple of years.
Markets have been on edge about the chances that the Fed could taper its QE bond-buying for several weeks, leading to a jump in interest rates and shaky stock prices. In the press conference, Bernanke expressed some bafflement about the bond market's behavior. Wednesday's selloff might befuddle him even more.
As University of Michigan economist Justin Wolfers tweeted: