Bernanke’s Exit Strategy
If the Fed’s intention is to prepare financial markets for a smooth exit from its expansionary non-standard policies, then Chairman Ben Bernanke has failed spectacularly up to this point. His press conference following the latest meeting of the Federal Open Markets Committee spooked investors and sparked a worldwide selloff of a wide range of assets. Emerging markets were particularly hard hit but Europe suffered as well. What seems to puzzle many investors is the fact that instead of correcting the impression he gave at a congressional hearing a few weeks ago (which made markets very nervous), Bernanke confirmed fears that he is looking for the exit, preferably sooner rather than later.
While talking to a European government official and using Bernanke’s car analogy, I was reminded of the fact that while it is true that lifting the foot off the gas pedal does not necessarily mean slamming on the brakes, what if your car is still climbing uphill?
That is exactly where the views of Chairman Bernanke do not match assessments about the economy he made in the past. Indeed, looking at U.S. employment figures (unemployment and the rate of labor participation), the dire situation in Europe, and the slowing of China and other emerging markets, it is understandable if investors believe that until now markets were pushed up by loose monetary policies rather than a significant improvement of the real economy. Bernanke’s upbeat tone simply does not match most available incoming data.
In this case, lifting the foot off the gas pedal could very well mean slamming on the brakes. So far markets have refused to accept the distinction Bernanke made between exiting QE3 and increasing interest rates. If markets continue to sell bonds, real interest rates will increase, no matter what the official Fed interest policy looks like.
However, if it is true that asset prices were increasingly divorced from the real economy, a market correction could prove to be healthy for the financial system. A closer alignment between asset price development and more stable, but still uninspiring, economic growth is not a bad thing, per se. Indeed, irrational exuberance, fueled by excessive liquidity, certainly is. If it is true that Bernanke will not serve for a third term, the next few months will determine how the Chairman will be remembered. He prevented the U.S. and world economy from plunging into a global depression. Whether he managed to push the U.S. economy back to self-sustaining growth through unconventional policies and managed to exit without causing any lasting damage remains to be seen. Entering the unconventional monetary landscape could prove much easier than exiting it. Bernanke has just opened a new chapter of central bank experimentation. It is going to be a very interesting read.