Jury still out on Bernanke stimulus

Markets have been on edge since the Fed chairman hinted he might turn off the money printing presses, writes Peter Leavis.

Amid the turmoil in global markets, one question is being obsessively debated on Wall Street: just what was Ben Bernanke thinking three weeks ago when he said the Federal Reserve might soon cut back its stimulus efforts?

While second-guessing the Fed is a parlour game that traders have played for decades, it is an exercise that has taken on heightened significance. In recent years, the markets have been more dependent on central bank support than at any time in recent memory. So when Bernanke, the Fed chairman, said the stimulus might diminish, alarm was bound to spread. And quite a reaction it was.

Since May 22, when Bernanke made those remarks, global sharemarkets have lost $US3 trillion ($3.1 trillion) in value, according to Bank of America Merrill Lynch.

The Japanese sharemarket lurched into bear-market territory this week after a sharp fall took the cumulative decline in the Nikkei 225 index to more than 21 per cent since a peak on May 22. The Nikkei bounced back on Friday but remains sharply lower.

While sentiment has been fragile as investors have taken stock of the economic policies of Prime Minister Shinzo Abe, markets in Europe and the US have been volatile as well.

Bernanke will get another bite at the apple at a scheduled news conference next week and in his semiannual testimony to Congress next month, when his comments will be closely scrutinised.

Here are four theories going around Wall Street on why the Fed chairman said what he said:

A bone for the hawks According to Fed observers, Bernanke has a consensual style of management on the all-important Fed committee that sets monetary policy. Some members have deep reservations about large bond purchases. Bernanke does not agree with the hawks, but he wants them to feel that their concerns are listened to.

So he makes an utterance that proves to them that he is not afraid to publicly envision a definite end to the stimulus. They then feel comforted that Helicopter Ben will have the resolve to stop the money drop - one day. This theory is great for the camp that thinks the Fed must keep pressing the accelerator. It means Bernanke was merely being a shrewd manager and is not going to turn stingy any time soon.

Bursting bubbles The Fed has a poor record of spotting bubbles and deflating them before they become destructive. There is no gigantic, overarching bubble right now that could harm the wider economy. Over the past two years, however, as the Fed has pumped money into the financial system, large markets have been driven higher by significant amounts of speculation.

A Fed governor, Jeremy Stein, has highlighted the risks in some of them. On Wall Street, with interest rates so low for so long, it has become easy to make bets with borrowed money. Such investments can unwind violently with even the slightest tightening of credit, however. Bernanke may have wanted to throw a little bit of sand into this giant leverage machine.

If so, it seems to have worked so far, because some of the frothiest markets have tumbled since his testimony. From the Fed's perspective, the risk is that the sell-off builds on itself and weighs on the wider economy.

Dress rehearsal One day the Fed will clearly state that it truly is going to pare back its purchases. That could usher in a turbulent period in the markets. Talking about such withdrawal today could soften any shock it inflicts on the market when it happens.

"You could see this as a trial balloon that was floated," said Brian Smith, who trades bonds at TCW, an asset management firm. "Bernanke might have wanted to see if the market could handle a tapering."

The Fed also gets to examine exactly how the markets reacted and can make tailored responses. In recent weeks, some important assets have been acting in weirdly interconnected ways (just search Google for the term "convexity vortex"). The Fed is now wiser about those sorts of moves.

A tap on the brakes The final theory is that Bernanke has in fact shifted his stance. While certainly not a hawk, he has intellectually moved closer to ending the asset purchases than people might realise. It is important to remember that the latest open-ended program was conceived at the end of last year, when there was great trepidation about the drag that fiscal retrenchment would have on the economy.

"Back in December, the Fed didn't know if we would fall off the fiscal cliff," said David Rosenberg, chief economist at Gluskin Sheff and Associates. "So it may have thought, 'We'll shoot now and think later."'

It turns out that, in spite of Washington's budget battles, the economy has been quite resilient. For the economic conditions that exist right now, smaller purchases might be more appropriate.

Some economists dispute this line of thinking. For instance, they say the Fed is not going to taper when the inflation rate is declining as it is right now. But Bernanke may think that dip is temporary, particularly since some forward-looking indicators in the markets predict a rise in inflation. And some economists see strong signs that the latest round of bond purchases is having its desired effect and will lead to a stronger economy as early as the second half of this year.

"Although the last three weeks have been jarring to everyone - including the Fed - its prime directive is to get policy correct, not worry about several weeks of increased market volatility," said Jim Vogel, a debt markets strategist for FTN Financial.