How Monetary Policy plays out in the Real World

The past week or so has shown hints of what is in store as the Federal Reserve hands back the reigns to the US economy.

The theory about the ramifications of the inevitable changes in monetary policy have been spelled out in this blog over the past couple of weeks (Caution - Windy Road Ahead) but market movements at the end of last week show how it will play out in practice.  Heavy selling last week was triggered by the rosy outlook painted by the chairman of the US Federal Reserve, Ben Bernanke, which was more upbeat than had been expected and is likely to signal that the end to bond buying by the Federal Reserve is nearer than many had thought.  It is worth taking a closer look at the reactions of the markets to get an idea of how future actions by central banks may impact on us all.

Bernanke’s statements around a week ago made the case that the economic recovery in the US was sufficient enough for the Federal Reserve to move forward with its plans to reduce its buying of bonds later in the year with a target of stopping completely in the middle of 2014. Pains were taken to get across the notion that the change in tact was not a tightening of monetary policy but just loosening at a slower pace and that any changes in monetary would depend on a continued recovery in the economy. Yet, because the bond buying by the Federal Reserve has become a crucial support holding up the prices of bonds and stocks, its imminent demise has rattled investors who were caught out by the bullish comments by Bernanke.  

The degree of surprise was spelled out in the sharp movements in the investment markets with prices of bonds plunging and the interest rate on 10 year US government debt jumping from around 1.5% to 2.5% (lower bond prices equate to higher interest rates). This will feed through into the real economy as government debt is typically the benchmark for which all other interest rates in the economy are set. The result will be higher interest payments for mortgage holders which will act as a damper on the promising recovery in the housing market in the US. The higher costs for borrowing will also be a point of concern for companies who are thinking of making new investments.

There are further negatives for the US economy from the changes in monetary policy – the ensuing volatility in the stock market will make households worry about their pensions and other investments making them less likely to spend. A slower pace of bond buying will result in a fall in the amount of new currency getting into circulation which will raise the value of the US currency.  A stronger dollar will make life more difficult for exporters, many of whom are already struggling in the global marketplace. 

This all puts the Federal Reserve in an awkward position of its own actions creating a headwind blowing in the opposite direction of where it is trying to get to – an end to its role of propping up the economy. Bernanke is trying to lessen negative effects of its bond buying plans by outlining in advance a clear schedule for its changes in policy. But the Federal Reserve also needs to ease concerns that it will act too fast and has allowed itself flexibility to modify its plans if the economic recovery weakens. The overall effect is the level of certainty which is craved by many investors will remain out of reach, and the twists and turns of monetary policy will be played out in jumpy markets that will keep everyone on their toes.