Enter Sandman?

Enter Sandman?

Julia Coronado - Market Economics
US Daily Spotlight | 09 Jul 2013 00:06 |

Markets settled down a little on Monday with Treasuries yields retracing nearly half their Friday spike and equities posting another modest gain closing just under 2% below their peak on May 21, the day before Chairman Bernanke effectively endorsed tapering. With little data to digest investors are looking to a series of bond auctions and a speech from Chairman Bernanke on Wednesday afternoon to set the tone. Bernanke will speak at a conference sponsored by the National Bureau of Economic Research (NBER) titled “The First 100 Years of the Federal Reserve: The Policy Record, Lessons Learned, and Prospects for the Future”. There is no title listed on the conference agenda but Chairman Bernanke closes the conference after four academic papers on political influences on Fed policy, international influences, appropriate design of a central bank, and the Fed’s track record on regulation. The lunch will feature a talk by Paul Volcker moderated by Martin Feldstein. The Federal Reserve Board has confirmed there will be a prepared text for the Chairman’s talk and he will take audience questions.

Ahead of any mysterious speech from Chairman Bernanke there is speculation as to whether he will say anything relevant for financial markets. Last year such speculation was rampant ahead of Bernanke’s August speech in Jackson Hole. After all, the data and financial markets had been improving after the extension of Operation Twist and it was thought that the Chairman might want to bide his time. But we were at a major policy crossroads, and Bernanke had a message to deliver.

Similarly we suspect we are at a policy crossroads now, and Bernanke has a message. Eight FOMC participants have delivered policy speeches since the June FOMC meeting with two of those in the unusual form of formal statements and press conferences. The Chairman is closing a major policy conference on the Fed’s first century before a multitude of monetary policy dignitaries—including Paul Volcker, Stanley Fischer, Christina and David Romer, Frederic Mishkin, Randall Kroszner, Alan Blinder, Jean-Claude Trichet, Don Kohn and others. It seems likely he will take the bull by the horns and lay out a vision for the Fed’s future with a semi-permanently expanded balance sheet. Next week he will speak for the Committee in his semi-annual testimony before Congress. On Wednesday he will lay out his own vision for monetary policy in a new era of low growth, inflation and interest rates unfettered by the critical eyes and political jockeying of elected officials.

We are more confident in speculating that he will say something relevant than in what he is likely to say. The Fed has been incorporating a new element into its reaction function. We know and understand more or less how the Fed looks at the data. What is less clear is how financial stability considerations are factored in. There are two sides to the financial stability coin—risks of instability from too much froth and leverage and risks of a premature and disorderly tightening in financial conditions. The FOMC may want to remove some froth, but it surely doesn’t want to derail an economy still fighting its way to escape velocity. We don’t at all think the Chairman will back away from recent guidance around tapering. But will Bernanke stress data dependence and the importance of preventing a premature tightening in financial conditions, or will he continue to insist that the mortgage market is “working quite well” and that they will address downside risks to inflation with zero rates. Will he indicate that the pace of tapering is hardly predetermined as New York Fed President Dudley did, or will he reassert as he did at the press conference following the June FOMC meeting that people’s optimism about housing will overcome the dampening impact of higher rates? Tapering expectations have been priced into markets to a large degree; Bernanke’s tone will matter for where markets go from here. Sleep with one eye open.