Up and Up

The Fed’s Spring Awakening

The Federal Reserve says the economy is getting better. So why are investors so miserable? By Daniel Gross.

Federal Reserve Chairman Ben Bernanke made a little news today. No, he didn’t shed any light as to whether he will be serving another term once his current term expires next January. (We can safely assume he won’t.) And no, he didn’t announce a significant, imminent change in the policy under which the central bank buys $85 billion of securities in a month. In its statement, the Federal Open Market Committee, the Fed’s policy-making body, basically said there would be no change to the quantitative easing policy, designed to keep interest rates low and support the economy.

Bernanke essentially said that he and his colleagues are now believers in the Recovery Spring theory—the heretical idea that the U.S. economy is powering ahead at a pretty good clip. In fact, the economy has been doing well enough for long enough that Bernanke said he could envision a time when the Fed wouldn’t have to support the economy by buying billions in long-term securities each month. Without giving concrete commitments, Bernanke said that if the economy continues to perform as the Federal Reserve expects, the taper—a reduction in the rate of asset purchases—could start later this year. Eschewing specific triggers, he nonetheless outlined some targets. When unemployment falls below 7 percent, the Fed would consider reducing the pace of asset purchases and ending them. When unemployment falls below 6.5 percent, the Fed might start considering rates.

In fact, the overall picture from inside the Fed is one that readers of this column may recognize—a relatively optimistic take on America’s short- and long-term prospects. Bernanke and his colleagues have been looking at the same data we’ve been looking at: the steady rise in jobs, consumption, and retail sales; the continuing recovery in housing; and even the coming end of state and local austerity.

There’s still the problem of the federal government, though, with its needless sequester. “The main headwinds to growth are, as you know, federal fiscal policy,” said Bernanke during today’s press conference. But given the headwind created by budget cuts and tax increases, he said, the fact that the economy is moving ahead is indicative that things are basically sound.

In fact, this spring, the Fed—like some other smart folks—has become more sanguine about America’s prospects. Check out the Fed’s projections for economic conditions for the next couple of years. Compared with the March forecasts, the June forecasts assume a slightly higher rate of growth, and slightly lower rates of unemployment and inflation. Recovery Spring!

All that sounds pretty good. But as Bernanke spoke, investors freaked out a little bit. The Dow Jones industrial average fell a little more than 200 points, or about 1.3 percent, by Wednesday’s close. And interest rates on government bonds rose. That is to say, investors were dumping both stocks and bonds. Which sounds only half right, given Bernanke’s forecast. If the economy is getting stronger, you would expect signs of inflation to pick up, and that would boost interest rates. What’s more, should the Fed reduce its asset purchases, it would remove a big player from the market. The rational reaction to both of these moves is to sell bonds.

But stocks are in large measure a bet on future economic growth. So if Bernanke is more optimistic about growth, why were investors suddenly more pessimistic about stocks? It’s basically a knee-jerk reaction. Think of stock investors like caffeine addicts who are told that the substance that improves their life and helps them get through the day is going to be less available in the future. Imagine someone told you you’d have to taper your coffee consumption. You’d throw a fit and be miserable. Well, the Fed has been like Starbucks for stock investors for the last several years. By buying bonds and keeping interest rates at rock-bottom levels, the Fed made stocks seem more attractive. The Fed’s efforts have also supported economic activity, which is good for stocks. And the last four years, in which the stock market has doubled as the Fed has relentlessly expanded its balance sheet, have conditioned stock investors to rely on the central bank.

While the Fed isn’t pulling back just yet, Bernanke did say that the Fed’s next move is likely to be a lower level of stimulus rather than a higher level. He was basically saying that the Fed could envision a day in the not-too-distant future when it wouldn’t have to provide so much support to the economy, and when money wouldn’t be free for banks. When that day comes, the financial system, and the economy as a whole, will have to work a little harder.