Chairman Bernanke Tracks Risks

Central bank’s policies have the potential to alter markets and erode confidence in the Fed, the chairman warns.

Milton Ezrati of Lord AbbettNow that the Federal Reserve has launched its third, open-ended, quantitative easing (QE3), investors need to consider the risks. Certainly Fed Chairman Ben Bernanke has. He outlined them recently at the Kansas City Fed’s annual conclave in Jackson Hole, Wyo. There, in addition to providing considerable perspective on the extraordinary steps the Fed has taken since the 2008-2009 financial crisis, the chairman reviewed four critical risks involved in non-traditional policy tools and procedures. He probably could have added a fifth.

Bernanke’s first concern has to do with liquidity. The massive size of the Fed’s quantitative easings, he said, leads him to worry that the markets in which the Fed operates could take on an administered character. That quality could drive out private trading and, with it, the price discovery and liquidity on which markets rely. Bernanke went so far as to say that the lack of a “free-trading” aspect in Treasuries and agencies, to use his words, could erode the lead these markets have offered in pricing and yield, making overall financial markets less efficient as well as weakening the overall effect of future Fed policy moves.

The chairman’s fourth and final concern dwelt on the potential for losses in the Fed’s now immense security holdings. Since the Fed turns all its profits over to the U.S. Treasury, any such losses would effectively add to the government’s budget deficit. Against this concern, Bernanke offered reassurance that the Fed’s purchases actually benefit taxpayers by reducing the federal government’s deficit and debt, presumably by holding down the cost of debt servicing. But he acknowledged that containing government debt is less important than the Fed’s efforts to stimulate the economy and so the country’s living standards.

These four concerns revolve around what Chairman Bernanke referred to as the Fed’s “balance-sheet tools,” but the Fed’s new “communications tools” raise a fifth and potentially serious risk. A great potential for heightened volatility lies in policy makers’ new practice of expressing their longer-term expectations of where interest rates are headed. When the Fed makes an interest-rate forecast, it effectively invites all investors to position themselves in a consistent way. Though the Fed qualifies its expectations by explaining that they depend on unfolding economic and financial conditions, the fact is that the public pays scant attention to such qualifications and believes instead in the Fed’s special insight and its power to enforce its expectations. As long as matters go as the Fed expects, this near-uniform positioning presents little risk. But if unforeseen events force the Fed to deviate from its stated plan, such common positioning will require the bulk of market participants to adjust, disrupting markets greatly and adding to volatility.

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