The recent gyrations of global markets illustrate the challenge Federal Reserve Chairman Ben S. Bernanke will face this week: how to communicate what the central bank plans to do with the trillions of dollars in securities it has bought in its efforts to revive the U.S. economy.
On June 19, at the end of a two-day policy meeting, Bernanke will address a world preoccupied with the Fed’s reaction function. For much of the past year, investors thought they had an understanding: The central bank would maintain stimulus “for a considerable time after the economy strengthens,” as Bernanke put it in October. Now, as Fed officials publicly discuss how they might adjust their bond-buying program according to the economy’s performance, investors are having doubts about Bernanke’s pledge.
Those doubts are having a big impact. Investors’ changing expectations for the future path of interest rates have helped push the yield on the 10-year U.S. Treasury note as high as 2.23 percent, up from a low of 1.63 percent in early May. The rising return on U.S. dollar investments has, in turn, made other countries look relatively less attractive, contributing to sharp drops in the currencies and stocks of emerging-market nations such as Brazil, India, Indonesia and Thailand.
Let’s be clear: The Fed’s job is not to keep markets going up or to protect investors from their own mistakes. Rising interest rates can be a positive sign that the economy is gaining momentum. It’s crucial that the Fed get its short-term interest-rate target back up from zero at some point. Otherwise, the central bank won’t have much power to fight the next recession by lowering rates again.
Right now, though, the outlook for the U.S. economy is far from stellar. The housing market is showing signs of life, but job growth is still mediocre and inflation is below the Fed’s target. The federal budget sequestration is creating drag by forcing immediate cuts in government spending at a time when more stimulus would be in order. Higher interest rates will only aggravate the situation by making it more expensive for people to buy houses and for companies to expand.
The Fed’s attempts at nuanced communication haven’t helped. Officials have tried to treat their policy on bond purchases, known as quantitative easing, as separate from their policy on where to set the short-term interest-rate target. The distinction is lost on markets: Both are tools for managing the level of stimulus, and are influenced by the same considerations. When the Fed promises to keep interest rates at zero for an extended period, then says bond purchases will depend on the economic outlook from month to month, it succeeds only in sowing confusion.
Bernanke needs to dispel the confusion this week. To that end, he should reinforce and expand the message he sent in October: The Fed is committed to maintaining stimulus until after the economy recovers, and this applies to all its operations. Such an unconditional statement, known as policy guidance, is the most effective way to give businesses the certainty they need to boost investment and hiring. As such, it’s the most direct route to a world in which the Fed would have good reason to start raising rates again.
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