Bernanke Hinted At A Slow Phasing Out Of QE3 And Markets Tanked, Proving That We Have A Fed Inspired Bull Market The Fed should stick to its main mandate to defend the currency. The attempt to force economic expansion creates too many distortions

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By Paolo von Schirach

June 20, 2013

WASHINGTON – “What the Fed giveth, the Fed taketh away“. This pretty much summarizes the (orderly but significant) June 20 sell off on Wall Street. Look, the massive drop (the Dow Jones lost 353 points) may be just a hiccup, an isolated event that does not indicate a trend. That said, it is clear that investors are selling stocks mostly because Ben Bernanke, the Chairman of the US Federal Reserve, just indicated in a press conference that at some point, may be next Spring, the “accommodating policies” the Fed has been pursuing may be phased out, albeit slowly and moderately.

Strong reactions to a mild statement

Now, Bernanke’s statement was hardly a bomb shell. He did not say: “We over did it. And now we announce the end of QE3 and the beginning of interest rate hikes”. He only said that, if indeed the economy will keep improving, (optimistic idea, if you ask me), the extraordinary measures taken by the Fed to boost expansion will be gradually phased out. Nothing shocking here.

And yet the markets reacted strongly to this mild warning about things to come, later on, with a major sell off. Whatever the ultimate meaning of this one day event, this strong reaction to a hint of future action is at least an indication that American capitalism, while of course driven by market fundamentals, is also inordinately influenced by the Fed. And we are talking here only about indications of future, moderate moves which may or may not take place, depending on objective labor market conditions. We are not talking about abrupt Fed announcements concerning major policy shifts.

A Fed induced stock market growth is not good

This cannot be good. In ordinary circumstances we should not have major market gyrations because of mild Fed announcements regarding possible, gradual actions that may or may not take place next year. These gyrations reflect the fact that we have had a Fed inspired stock market rally and that all investors are acutely ware of this fact. Any hint that the party may be over causes sudden fear attacks. Which is to say that the June 20 sell off had nothing to do with objective market conditions. Investors acted only on the basis of their perception of policy changes impact.

Indeed, we know that for ostensibly noble reasons the Fed created an environment in which the only way to make some money is to invest in stocks. As a result, we no longer know the actual value a stock because, beyond objective facts affecting stocks valuations, we have inflated prices due to Fed actions that made it impossible to make money through other forms of investments.

And market players are so conscious of the Fed role in creating this overvalued market that when Bernanke said that current policies at some point will be gradually phased out many investors decided that the party is over and that it may be wise to quickly get out of Wall Street while the going is still good.

Well, if you thought that stock valuations were a reasonable reflection of the health of the American economy, think again. Sure enough there are basic factors that cannot be ignored.  But when you add to the mix the tons of steroids ladled by the Fed in the last few years, you have equity markets that look a lot better than they really are. It is a very distorted and therefore deceiving picture.

Let people invest on the basis of real market conditions

My simple conclusion is that the Fed should stop meddling. For that to happen the US Government should end the Fed’s mandate to secure full employment. This mandate allows (forces?)  the US  Central Bank to manipulate economic  incentives in order to support growth, up to the point that we no longer know what is “real” and what is Fed induced.

The attempt to boost more economic expansion, so that more people will get jobs, is noble. Still, in the long run allowing economic actors to deal with reality as it is is a lot better. Let people buy stocks because they are worth something; and not because –due to Fed policies– there are no returns on other forms of investments.

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