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The Economist: Overreaction and irony

By By Ray Perryman
July 6, 2013 at 2:06 a.m.


Federal Reserve Chairman Ben Bernanke recently set off a firestorm when he indicated that the temporary and extraordinary measures the Fed has taken to help the economy recover from the recent recession would at some point yet to be determined precisely be phased out.

The reason for the mention of tapering off is that, in the Fed's view, the economic recovery might be close to reaching the point where it can continue on and gain momentum even without the Fed's help. The risks to the economy have diminished since last fall, the job market is better, and the housing market has improved.

This is good news, right? Wrong. At least not judging by the way the investment community reacted. The Dow dropped more than 200 points after the announcement, and other major market indices took similar hits. The reaction was both overblown and ironic in several ways.

One notable point is that the selloff was based on so little new information. Everyone has always known that the high levels of bond purchases by the Fed would end at some time. Chairman Bernanke basically said if this and this and this, then maybe that and that and that unless something else happens, and we will continue to monitor the situation and adjust accordingly.

There were caveats aplenty and room for a change in plan at the least signal that there was a need. However, folks reacted like he said a nuclear weapon would hit their house in 30 seconds.

He used an analogy of driving a car, saying that "any slowing in the pace of purchases will be akin to letting up a bit on the gas pedal as the car picks up speed, not to beginning to apply the brakes."

Bernanke continued with the automobile analogy, indicating that "if the incoming data support the view that the economy is able to sustain a reasonable cruising speed, we will ease the pressure on the accelerator by gradually reducing the pace of purchases." He was quick to point out that "any need to consider applying the brakes by raising short-term (interest) rates is still far in the future."

Ending the Fed's stimulative actions because of improvement in the economy is clearly a good thing from almost any perspective you choose. Some analysts have feared that the Fed's actions could lead to major long-term problems such as spiraling inflation, a weakening dollar and more.

These risks - while somewhat overstated, in my opinion - increase if we keep up the quantitative easing too long. If the Federal Open Market Committee is beginning to see the light at the end of the tunnel, it's good news.

The fact that the economy is improving should also be good for equities markets, as it bodes well for corporate growth and earnings and returns to investors. So why did stocks tumble? Largely because of the fear that long-term interest rates will rise when the Fed takes the foot off the gas (which is likely true).

However, it is important to note that if the Fed doesn't ease up on the easing once the recovery revs up, the excess money in the system will fuel inflationary fears.

In an environment with higher inflation, bond buyers and lenders demand higher rates to protect against negative real returns. Ironically, long-term interest rates would rise either way and actually more if investors become convinced the Fed is not going to act.

Some analysts have set forth the opinion that the reaction was more because of the stock market being primed for a correction than what was actually said in the announcement.

While the investment community has long obsessed about the Fed's actions and the Chairman's words, the size of the drop was partly a case of markets looking for an excuse for a correction. There's probably some truth to that notion given the way it kept drifting down and is now beginning to drift back up.

Mr. Bernanke said that "our policy is in no way predetermined and will depend on the incoming data and the evolution of the outlook." We knew this fact years ago. While there was a little acknowledgement of the fact that the economic recovery might be reaching a point where it makes some sense to think about thinking about tapering off, it was carefully couched in terms of happening if and only if the recovery is at a stage to warrant.

Although there will inevitably be a period of adjustment when the Fed stops its accommodating policies, I for one hope that it's sooner rather than later.

M. Ray Perryman is president and chief executive officer of The Perryman Group (perrymangroup.com). He also serves as institute distinguished professor of economic theory and method at the International Institute for Advanced Studies.

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