World markets should not be surprised by Bernanke’s message

That US$85-billion a month bond-buying fix, which the WSJ columnist mused helped transform global markets into “a giant crack house” by keeping long-term interest rates low, is about to come to an end. Cue the ensuing turmoil: Stock markets went into a free fall for 48 hours following Mr. Bernanke’s comments on June 19, sparking the largest drop for the S&P 500 index since 2011. The Dow shed more than 500 points and bond markets, which had been anticipating for weeks that the Fed would cut back on its bond purchases, fared no better as the yield on the U.S. benchmark 10-year bond climbed .25 basis points to 2.5% by week’s end. There was no less carnage in Canada’s financial markets, where the S&P/ TSX composite index fell about 400 points, but rebounded slightly to end the trading week down 192 points.

All over the world, investors and money managers who saw their retirements slipping further away went into a collective shock, lamenting they’d been somehow blindsided by the Fed. Even within the Federal Reserve system, which is made up of the 12 state reserve banks, dissension seeped into the public as St. Louis federal bank president James Bullard questioned whether Mr. Bernanke had “inappropriately timed” the Fed’s decision to turn off the taps.

The horror rings a little hollow. Investors can be forgiven for being delusional enough to believe the era of easy, cheap money would last forever, but not the folks who sit around the table with Mr. Bernanke. Mr. Bullard is one of the five regional federal reserve representatives on the powerful open market committee, along with Mr. Bernan-

All Bernanke did was signal a change was

going to happen

ke. If anyone would have been privy to the plan, it was Mr. Bullard and his regional colleagues.

Clearly, transitioning the Fed’s monetary policy to what’s good for the economy isn’t always good for the stock market, or your retirement portfolio. Stimulus spending is intended to nurse an ailing economy to health, not to be an endless source of easy money for investors. The Fed’s twin goals are to keep unemployment and inflation low. In Canada, the Bank of Canada’s only objective is keeping inflation between 1% and 3%. For the market to think that the Fed or any central bank can save the economy is misguided.

“Other than in the short run, central banks can’t really do that much to affect the real economy,” says Jack Carr, professor of economics at the University of Toronto. “They can shock it, but I doubt there’s been much effect on the real economy in recent years as a result of Fed policy.”

Having prevented the worst financial crisis since the Great Depression, the money supply hasn’t been increasing as much because the Fed has been taking other actions that counteract that. Inevitably, the stimulus taps that were turned on in 2008 would be turned off. The only real surprise is that it hasn’t happened sooner. Prof. Carr reckons that Mr. Bernanke has been under political pressure to keep the policy in place at least until after the 2012 presidential election. Now, economic indicators don’t justify the Fed’s continued aggressive intervention, he says. Generally, stimulus policies begin to wind down when an economy starts showing signs of strength. Recent U.S. economic data has finally given the Fed the impetus to change the course of its monetary policy: economic growth has been steady for at least 12 straight quarters, unemployment is 7.6%, down from double digits, inflation is below the Fed target of 2% and even the decimated housing market is on the road to recovery.

To his critics Mr. Bernanke is attempting to wean the U.S. economy off easy credit at a time when the pace of economic growth in the U.S. and Europe is far from robust. Prof. Carr says he’s amazed at the “overreaction” even though the Fed hasn’t actually done anything yet — all Mr. Bernanke did was signal a change was going to happen down the road. In these fragile times, just knowing that the prospect of an era of high interest rates is closer is enough motivation for the markets to change course, at least temporarily.