As readers of this column know, I have enthusiastically
supported the policies of Federal Reserve chairman Ben Bernanke
since the Lehman Brothers bankruptcy five years ago. So I'm certain
that most people believe that a stock market bull like me would be
enthusiastic about the Fed's decision to delay tapering its
bond-purchase program. But I believe that Bernanke and the Fed have
made a serious error.
By adopting a policy that was well outside the expectations of
virtually every market watcher, the Fed damaged its most valuable
asset: credibility. In the future, the Fed will have a much tougher
job convincing the markets that it means what it says. That, in
turn, reduces the impact of "forward guidance," one of the Fed's
most useful monetary tools.
Forward guidance allows the central bank to influence key
economic variables, such as stock prices and long-term interest
rates, simply by stating what its future policy will be. For
example, if the central bank wants to restrain the economy, it
telegraphs that there is a heightened probability of a future
tightening move, such as an increase in short-term interest rates.
The impact of those words alone may prompt an increase in long-term
rates. That may be sufficient to reduce the size of any move by the
Fed to bump up short-term rates--or possibly eliminate the need
It's true that Bernanke never promised that the Fed would begin
tapering later this year. But he must have been aware of the
market's overwhelming expectation that the Fed would announce a
move in that direction. If he harbored doubts that the Fed should
begin a tapering policy, it was incumbent on him to alter the
market's expectations by signaling that doubt in speeches, public
testimony or other communications before the Fed's September
To be sure, economic data had been on the weak side since the
Fed's previous meeting in July. But the figures were not so weak to
justify the Fed thwarting market expectations so thoroughly. If
Bernanke wanted to err on the side of caution, he could have eased
up on bond purchases by $10 billion instead of $20 billion, as
expected by the market. Or he could have reduced purchases of
Treasury securities but not mortgage-backed securities, or given
guidance that further tapering would be halted if economic activity
did not pick up. Any one of those actions would have been in line
with the low end of market forecasts, maintained Fed credibility,
and given a boost to both stocks and bonds.
A tougher challenge. Now, however, it will be more difficult for
the Fed's words to move markets. Analysts and investors are likely
to react to any of Bernanke's warnings with a "show me" attitude.
As a result, the Fed will have to use more aggressive policy
tools--such as lowering or raising reserve requirements, which
makes it easier or more difficult for banks to lend. Those policy
options are more disruptive and generate more uncertainty than
using forward guidance to set market expectations.
I can understand that Bernanke might have believed that the
market overreacted last spring when the Fed first announced its
intention to begin easing up on bond purchases. But to do nothing
is not the solution. It merely hurts the Fed's credibility.
The Fed's mistake is not fatal. In fact, some people may view
Bernanke's decision as prescient, given the subsequent government
shutdown and budget squabbles in D.C. But with a new chairman in
the wings, it's critical to maintain market confidence in the Fed's
word. It has been said that reputation is more important than
money. For the institution that prints our money, those words are