What set me off this morning is the headline on Bloomberg, "Dollar Bulls Waver As Fed's Signals Whipsaw Traders." The key words: "Fed's signals" and "whipsaw traders." As we have seen over the last several weeks, the comments of Federal Reserve officials, especially Mr. Bernanke, have sent markets moving; first one way and then another.
One of the major rules of conducting monetary policy used to be that the Federal Reserve did everything it could to help financial markets adjust smoothly. That is, whatever officials at the Fed said or whatever actions the Fed took should result in financial markets moving incrementally, not in discrete jumps and particularly wide swings!
Of course, they did not always achieve such a goal. I remember visiting the Federal Reserve one time when the markets took a very discrete jump. The Federal Reserve had been allowing short-term interest rates to drift lower and lower for several months. Then concerns arose that the U.S. dollar was falling more than desired so that the Open Market Committee voted to reverse the decline in the Federal Funds rate so as to protect the dollar.
The Federal Reserve, at that time, controlled the Federal Funds rate within a range of about 50 basis points. The Open Market Committee made its decision on a Tuesday. On Wednesday morning the new operating range was introduced at the Federal Reserve Bank of New York. The new target range overlapped the old range so that market rates could vary without committing the Fed to any kind of action or inaction.
On Wednesday, the Federal Funds rate drifted upwards but remained within the old target range. However, on Thursday, the Federal Funds rate continued to drift upwards and broke the ceiling of the old range. I was sitting on the trading desk of the largest investment bank in New York at that time. Once the Federal Funds rate hit the old ceiling -- and then went through the ceiling -- within seconds the whole, enormous trading room went silent.
Expectations had been broken. Traders now had to discern what the Fed's new trading range was. There was a discrete jump, not an incremental movement, in short-term interest rates that day and also that Friday.
But, situations like this tended to be rare. The Federal Reserve, at that time, did all it could to foster smooth adjustments to changes in monetary policy. And that included what was said by the officials of the Fed, especially the chairman of the Board of the Board of Governors. The chairman attempted to excel in the art of transmitting the thrust of monetary policy as obscurely as possible. People didn't trade a lot after the chairman spoke because everyone was always trying to figure out exactly what it was that the chairman said.
Chairman Bernanke has generally wanted people to understand what it was he was saying when he spoke. During his tenure, he has made special efforts to convey to financial markets what it was he was trying to do. I have written about this many, many times over the past five years or so. Perhaps my most explicit post came on March 20, 2012: "Ben Bernanke: 'Please Understand Me!'."
It is no wonder, therefore, that when Mr. Bernanke spoke about the "tapering" of Federal Reserve securities purchases, the market reacted. Mr. Bernanke had been saying that the Federal Reserve would purchase $85 billion in U.S. Treasury securities and Mortgage-Backed securities for an extended period of time and that the Federal Funds rate would be kept near zero into 2015 -- a long time into the future.
Then, Mr. Bernanke, who has struggled to be "understood", says that the Federal Reserve may be "tapering" off the amount of purchases from the $85 billion amount each month. The analogy was used that this was not really a change because it was like the driver of a car easing off on the gas pedal -- the car was still going fast, just not quite as fast.
The market responded but, you, the Fed, have broken expectations and reacted accordingly. Wrong analogy!
After several other Federal Reserve officials tried to mend the damage, Mr. Bernanke had to speak again and calm the financial markets by saying that talk of "tapering" was premature and "tapering" was really not going to happen anytime soon. So, traders were whipsawed!
As the economist John Taylor wrote on July 11 in the Wall Street Journal, "the return to conventional monetary policy is still a long way off." Unfortunately …
Mr. Bernanke, however, has never really exhibited an understanding of banking and financial markets. He was a world-renowned expert on the history of the Great Depression. He used this knowledge during the Great Recession of recent years and will be known for the monetary policy created during this time, a policy I have called the "throw all the 'stuff' you can against the wall to see what sticks" policy. And, the policy worked. It was not conventional but to stop a cumulative downward spin to the economy, it did the job. Unfortunately, he has continued to throw "stuff" against the wall for the past four years since the end of the recession, even though the policy has seemingly had little impact on stimulating faster economic growth.
However, there is all the other time that Mr. Bernanke has spent at the Fed. In his earlier service as a Governor during the tenure of Chairman Alan Greenspan, Mr. Bernanke was a strong supporter of the low interest rate policy of the early 2000s to avoid a deeper recession following the March 2001 to November 2001 recession. Then he started raising interest rates to combat a possible renewal of inflation. In both case, he, along with Mr. Greenspan, was completely clueless about the possibility of bubbles -- in the housing sector or in the stock market -- until the financial crash that began on August 7, 2007 took place. Mr. Bernanke seemed to be stunned at what happened.
Mr. Bernanke is an academic economist along with many of his fellow officials at the Fed. It is interesting how the press made such an issue out of the fact that Fed Governor Elizabeth Duke, who just announced her retirement from the Federal Reserve Board, was the ONLY member of the Board of Governors that had any banking experience. She is the only one that had really worked in financial markets!
In conclusion, I am really concerned about what the future holds for monetary policy. Mr. Obama has signaled that Mr. Bernanke is out after his term expires in January 2013. I don't see anyone at the Fed, or who has been listed as a possible successor, that has any real market experience. This bothers me. People without real market experience cause market volatility. Mr. Bernanke certainly has. What this means is that the volatility of financial markets will continue and might even get worse as "tapering" actually begins and as the Fed leaves quantitative easing behind.
If you are an investor, you need to plan out how you are going to operate in a financial world where there is substantial amounts of volatility in the market. You must either be very, very patient if you are a value investor, or, you must be very, very nimble if you are not a value investor. Continued uncertainty in world financial markets with slower global growth will just exacerbate the situation.