Bernanke walks fine line on tapering

The Federal Reserve Chairman has made it clear that the federal funds rate will remain close to zero for a long, long time.

The intentionally manipulative actions of central banks when it comes to liquidity and allocation of capital has made investors more interested in future monetary policy decisions, especially when it comes to the world’s largest economy.

Central banks have not historically been in the business of trying to manipulate financial markets through commentary alone. Current Federal Reserve Chairman Ben Bernanke’s speech today confirmed the US central bank is well aware of how it must communicate with the market to achieve the desired outcome.

After the Fed’s gaffe earlier in the year about tapering, Bernanke’s speech was firmly trying to set market expectations concerning any changes to the federal funds rate. Commentary from the Federal Reserve is enough to push equity markets to dizzy highs and promptly move yields on the benchmark interest rate measure, the 10-year Treasury note.

When quantitative began five years ago it was enough to almost halve the yield on the 10-year Treasury note. Ever since, movements in the 10-year Treasury note have largely been dictated by the market’s interpretation of commentary from the Federal Reserve.

It is a very simple relationship – confirmation of more and more quantitative easing equals lower Treasury yields. Conversely, ambiguity over the future of quantitative easing sends Treasury yields marching higher.

Bernanke is telegraphing to financial markets that the federal funds rate will continue to border on zero for some time yet. A really, really long time even. We can translate this to mean lower rates both at the short and long end. Longer term rates, measured by the yield on the 10-year Treasury note were quick to rocket higher at the thought of tapering.

Future changes to the federal funds rates will be tied to two key economic objectives – an unemployment target rate of 6.5 per cent and a long-term inflation goal of two per cent growth. Apparently these measures are not triggers, rather only signals to begin considering a higher federal funds rate.

But before the market can even worry about a rise in the federal funds rate, the current liquidity tap must be turned off. It is a realistic possibility the US economy is at risk of inflation, especially if banks begin to monetise their cashed up balance sheets, consequently forcing the Federal Reserve to hike the federal funds rate.

At the end of the day, the credibility of the Federal Reserve is on the line if the future of monetary policy, and specifically quantitative easing, continues on as it is. It simply isn’t technically or politically viable to pursue such an aggressive monetary policy forever.