The markets are getting rocked in the aftermath of Fed Chairman Bernanke's broad hints last week that the Fed is preparing to gradually reduce its presence in the credit markets.
Although Bernanke tried to soften his statements by saying the end of QE3 would depend in part on a continued improvement in the domestic economy, the market is reacting as if the Fed has already left the party:
A number of observers are questioning whether the Fed is being overly influenced by political pressures in Washington. Here's Paul Krugman writing in this morning's New York Times:
In any case, my guess is that what’s really happening is a bit different: Fed officials are, consciously or not, responding to political pressure. After all, ever since the Fed began its policy of aggressive monetary stimulus, it has faced angry accusations from the right that it is “debasing” the dollar and setting the stage for high inflation — accusations that haven’t been retracted even though the dollar has remained strong and inflation has remained low. It’s hard to avoid the suspicion that Fed officials, worn down by the constant attacks, have been looking for a reason to slacken their efforts, and have seized on slightly better economic news as an excuse.
And maybe they’ll get away with it; maybe the economic recovery will strengthen and all will be well. But rising interest rates make that happy outcome less likely. And now that everyone knows that the Fed is eager to slacken off, it will be hard to get interest rates back down to where they were.
And Evan-Pritchard makes a very strong case that the Fed is ignoring a number of very ominous signs that deflation - not inflation - is a more serious risk at this juncture:
It has chosen to tighten monetary policy even though core PCE inflation is actually lower right now than it was when the Fed previously thought it dangerous enough to launch further QE. America is one shock away from a slide into outright deflation, and the eurozone is half a shock away....
... Nevertheless, I am frankly flabbergasted by the actions of the Bernanke Fed at this point.
They are gambling that the US economy will shake off the effects of fiscal tightening of 2pc to 3pc of GDP this year, arguably the biggest squeeze in half a century. It may indeed do so, but it may not, and the costs of making a mistake before the US recovery is safely established are asymmetric.
I have one theory about Bernanke's announcement.
A couple of weeks ago, President Obama made an off-hand comment that suggested that Bernanke's term as Fed governor might soon be coming to an end. The President suggested that Bernanke had actually wanted to retire earlier, but had either been persuaded or reluctant to leave the Fed while his historic monetary intervention was still in place.
Bernanke may simply be starting the process that he would like his successor to follow, which would allow the new Fed chair to continue "tapering" the Fed's intervention with less political heat.
Or it could simply be that he truly believes that the time has come for the Fed to gradually withdraw from the markets.