Bernanke's comments on the Federal Reserve's quantitative easing program last Wednesday whipped the markets into a frenzy. Immediately the markets fell and extended their declines to Thursday in the worst two-day sell-off this year.
On Thursday, the markets unhinged across the board. The S&P 500 plummeted 2.5 percent, the Nasdaq declined 2.28 percent, and the Dow Jones Industrial Average fell 2.34 percent. Precious metals were crushed as the price of gold fell 7 percent and the price of silver tumbled 9 percent. Other commodities were also hit, with WTI oil prices declining 3 percent and natural gas prices falling 2 percent. Inversely, bond yields also soared, with the 10-year Treasury note climbing to 2.42%, the highest level since August 2011; almost every major bond market across the world was also hit with yield spikes.
Quantitative easing played a large part in the stock market's recent rallies through keeping interest rates low, which in turn encouraged investors to borrow and move into riskier assets such as stocks. Thus, the markets are sensitive to any remarks that may signal even an increased willingness of the Federal Reserve to slow down its quantitative easing program.
However, the huge market reaction to a potential Federal Reserve tapering, or slowdown of its quantitative easing program, is vastly overblown. For one, the Federal Reserve will only taper if it is confident that the U.S. economy is strong enough to significantly grow on its own. Bernanke knows that any premature drawdown of quantitative easing would be detrimental to a fragile economy and understands that it would be foolish to set a specific deadline for any tapering. Bernanke has even emphasized in the press conference that crushed the markets that the Federal Reserve's policy "is in no way predetermined and will depend on the incoming data and the evolution of the outlook." The Federal Reserve's decision to taper will eventually come down to consistent economic data that paints a picture of an economy that is gaining traction. If anything, the slowdown of quantitative easing would be a nod to the economic strength that should buoy the markets.
Yet, we're far from that level of economic strength. Just recently, revised figures show that GDP rose only 1.8% between January and March instead of the 2.4% increase previously reported. This shocking disparity can be attributed to the drop in personal consumption growth to 2.6% from a previously recorded 3.4%. This drop in personal consumption growth is in part due to fiscal austerity measures. Namely, an increase in payroll taxes and the fallout from the sequester and fiscal cliff have discouraged personal consumption and increased economic uncertainty among consumers. As noted by Millan Mulraine of TD Securities, "The lower consumption estimate provides some indication that the impact from fiscal austerity may have been more than previously thought, and that the economy started the year on weaker footing than previously estimated." Moreover, since the effects of fiscal austerity are expected to accelerate in the second quarter, Mulraine believes that the economic recovery in the second quarter will "slow even further to around 1.5% quarter/quarter." Since the Federal Reserve will initiate tapering only when it considers the economy to be healthy enough to rebound on its own, there may very well be quite a ways to go before the economy absorbs the full effects of fiscal austerity and grows fast enough for the Federal Reserve to justify any drawdown in asset purchases.
Moreover, the much ballyhooed about 7 percent unemployment mark that Bernanke has stated could be a point where asset purchases come to an end has also been rashly interpreted by the market. Although 7 percent unemployment may seem too high (Bernanke himself said that he now considers full employment to be 5.5 to 6 percent) and too close in the future (the current unemployment rate is 7.6 percent), it is by no means a trigger to kill quantitative easing. Instead, a 7 percent unemployment rate would simply be a threshold that, if reached, would lead the Federal Reserve to consider the appropriateness of its quantitative easing program. The same goes for the federal funds target rate, which the Federal Reserve would only even consider increasing if unemployment reached 6.5 percent.
These unemployment thresholds aren't the only figures the Federal Reserve is looking at to consider an appropriate monetary stimulus response. The unemployment numbers don't include discouraged job-seekers, those that went back to school, and those that have retired but does count those that "work" for as little as an hour per week.
That's why another statistic, the employment-to-population-ratio (EPOP), has often been used by the Federal Reserve in the past to justify specific actions such as the lowering of the federal funds' target rate. And right now, the EPOP isn't doing well. At a current 58.6 percent, it's stuck in a rut that shows that although jobs are being created, they are being created largely on the same pace as population growth.
Source: Bureau of Labor Statistics
As shown in the chart, there was a significant decline in the EPOP during the recession. Pre-recession EPOP levels were regularly above 63 percent. Now, even as the unemployment rate is lowering and the economy is gradually recovering, the EPOP can't even crack 59 percent and is still stubbornly stuck in its recession levels. The Federal Reserve, well aware of the EPOP, will not taper unless it sees signs that persuade it that the labor market is seeing real, meaningful growth.
On the other side of the equation, inflation is still extremely low. The core personal consumption expenditures inflation measure (preferred by the Federal Reserve) is at 1.05 percent, the lowest level ever. The current annual inflation rate is at 1.40 percent and inflation levels in general are nowhere near the Federal Reserve's target inflation rate of 2 percent.
The economic climate is still ideal for the Federal Reserve to continue its quantitative easing. Simply put, inflation is still stubbornly low while unemployment is still stubbornly high. And if the economy does pick up, the markets should rejoice, not lament the monetary stimulus it will no longer need. Last time I checked, if a patient's broken leg has healed enough so that he/she can walk without the help of any crutches, the patient doesn't beg the doctor to keep using the crutches.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.