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Saturday, Jan 21, 2017

Bernanke's sneeze - and the results

Stocks worldwide fell after Federal Reserve Chairman Ben Bernanke's June 19 statement on U.S. monetary policy. Emerging markets were hit especially hard. The statement, and Bernanke's comments afterward, shouldn't have come as a surprise - so what's going on? Was the sell-off a meaningless overreaction, or a warning of new financial stresses ahead? A bit of both. Bernanke said the Fed's program of quantitative easing would be reduced over the next year or so, and probably ended in 2014 - so long as the economy continued to strengthen as the Fed expects. He also repeated his plan to keep short-term interest rates on the floor for longer than that. Again, none of this was unexpected. It would have been shocking if he'd said anything else. In that sense financial markets overreacted, as they are apt to do. But Bernanke also focused investors' attention on the challenges of a return to normalcy in global financial conditions - because that's what the tapering of QE and the (still distant) prospect of higher short-term interest rates represent. Monetary policy quite rightly went far out on a limb in the aftermath of the recession, and getting off that limb was never going to be easy. Anxiety over this maneuver isn't misplaced.
For the past several years, central banks, led by the Fed, have provided extraordinary liquidity to global markets, driving down interest rates and leading investors to search far and wide for decent returns. Capital has flowed into emerging markets. As normal prices and valuations are restored, these flows are bound to be partially reversed, and assets whose prices were bid up will get cheaper. The process had already begun; this week it accelerated. The danger is that the adjustment will be so abrupt that it causes collateral damage, or that asset prices might fluctuate wildly as the market finds equilibrium. It has long been argued that there'd be less volatility if policymakers made their intentions clearer, but at the moment this doesn't look so plausible. Bernanke has worked hard to provide greater transparency about the Fed's thinking, and it hasn't helped. To paraphrase the bumper sticker, volatility happens, and there's not much policymakers can do about it. But they can help their economies and financial systems to take these lurches in stride. The right thing to ask of governments is greater resilience. That's within their power to deliver.