* Article * Comments (5) Real Time Economics HOME PAGE » * smaller * Larger * facebook * twitter * google plus * linked in * Email * Print * facebook * twitter * google plus * linked in * Email * Print * smaller * Larger * facebook * twitter * google plus * linked in * Email * Print By Michael S. Derby This most likely wasn’t the reaction Federal Reserve officials wanted. Getty Images In the wake of the Federal Open Market Committee meeting that ended Wednesday, the central bank’s unambiguous signal that it will begin to ramp down its bond-buying stimulus program in coming months has unleashed a wave of market pain. The question for central bankers is: does the tumult represent a short- term adjustment to a changing policy landscape, or an enduring threat to better growth? For now, answers are elusive. For one thing, the Fed meeting outcome is only a day old. While astute market observers shouldn’t have been surprised the central bank was near to shifting gears, it’s no shock markets might face some bumps as investors and traders price stocks, bonds and other assets for a world where the Fed will be providing less stimulus. Reduced Fed aid is, of course, a step on the road to an outright tightening in monetary policy, and markets need to be forward-looking. The market pain, if it continues, can wound the economy in two ways. Rising bond yields boost borrowing costs. Falling stock markets can erode confidence in the outlook and cause spending to fall, as households perceive a reduced “wealth effect,” however ephemeral that concept may be. Fed officials could at some point find themselves having to argue financial markets are going too far. That will be hard to do because many in markets already can’t understand the idea that a reduction in Fed bond buying is just a lowering in the amount of stimulus. Tighter monetary policy, the kind that would really drive borrowing rates up, means the Fed is in some fashion allowing its balance sheet to grow smaller, and raising short-term rates. An outright move toward restrictive monetary policy lies several years off, Fed officials believe. For now, economists reckon the Fed has time to take stock of things. Most forecasters see a limit to how far the market might sell off. Still, “the direction of the risk is clear. There is certainly a risk interest rates can derail growth,” said Dana Saporta, economist at Credit Suisse. She said so far the idea slower bond buying isn’t a tightening in policy “is lost on the market.” Ms. Saporta believes the Fed will be watching to see how far markets go before doing anything to turn things around. Ms. Saporta noted the mortgage market could be the key variable for the Fed. She noted at certain junctures a rise in yields can spark technically driven selling that could drive up borrowing costs more starkly. That would be particularly unwelcome given the definitive role low mortgage rates now play in the housing sector’s recovery. So far, most economists think the market will ultimately settle down once investors come to term with the reality of what changes in monetary policy mean. But at the same, bond yields, depressed by years of Fed bond buying, are going to go higher over time. Deutsche Bank economist Joe Lavorgna said in a note to clients what is now a 2.44% 10-year Treasury bond yield–that level is a critical barometer of long-term borrowing costs–will likely rise to 2.75% or higher as the year progresses. The economist sees a “natural limit” to how high the security can rise, and said the experience of other cycles where monetary policy was getting tighter suggests a 4% yield, which wouldn’t be historically unusual, isn’t going to happen any time soon. In the wake of the Fed meeting, Capital Economics said it has revised up its estimate of where yields are heading. It now sees a 3% 10-year yield next year and a 3.5% yield in 2015, when the Fed is expected to raise rates for the first time since cutting them to zero at the close of 2008. Meanwhile, the firm sees the likely path of Fed policies as a plus for the stock market: “We expect steady gains in equity prices–nothing spectacular, but better than many might fear against a backdrop of rising bond yields.”
Posted on: Fri, 21 Jun 2013 01:33:23 +0000