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The chill in Bernanke's words

Ben Bernanke, who wants to make clarity the theme of his Fed chairmanship, is discovering -- perhaps inadvertently -- that his words can send the markets careening.
/ Source: Business Week

Ben Bernanke is getting a taste of just how hard it is to turn theory into practice. The former Princeton University economist, who wants to make clarity the theme of his Fed chairmanship, is discovering — perhaps inadvertently — that his words can send the markets careening. "He came in on this message of clarity, and it's clarity that's getting him in trouble," says Jim Paulsen, chief investment strategist at Wells Capital Management.

In the latest incident of Fed-led market gyrations, Bernanke told an audience of bankers at the International Monetary Conference in Washington on June 5 that "core inflation...has reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability and the promotion of maximum long-run growth."

Investors, who just weeks ago expected the Fed to take a break from raising interest rates, took the comments to mean another rate hike is on the way. Futures traders expect the Fed to raise interest rates by another quarter point, to 5.25 percent, at its next meeting, on June 28 and 29. The Dow Jones industrial average plummeted by nearly 200 points on June 5, with Caterpillar down 5 percent, Alcoa off 4 percent, and American Express and JPMorgan Chase each down 2 percent.

No hiding
If market volatility is any measure, the new Fed chairman has had a rocky start. Bernanke, who took over the chairmanship on Feb. 1, began his new job at an especially tough time. Since June, 2004, there had been 14 consecutive rate hikes. As higher interest rates slowed down the economy, the Fed had to decide when to slow down the lockstep increases.

Currently, neither the Fed nor the markets know when the magic pause might come, as they sift through conflicting information showing either a slowing economy or growing inflation.

But Bernanke himself may have fanned some of the market's ups and downs. The new Fed chief believes that showing the central bank's true intentions — especially its inflation-fighting resolve — helps tamp down prices by keeping the public's inflation expectations in check.

Mistaken markets?
His first test of that theory yielded mixed results. At a congressional hearing on Apr. 27, Bernanke stated the possibility of a pause in Fed rate hikes, and added that a hiatus didn't necessarily mean an end to rate hikes. The Dow rose by 30 points.

Four days later, the markets took a tumble when CNBC anchor Maria Bartiromo [a regular Business Week columnist] reported that Bernanke told her at a Washington dinner that the markets misinterpreted his remarks as too dovish. Bernanke later apologized to a member of Congress at a hearing for the offhand comments to Bartiromo.

The markets have since been on edge over the uncertainty as to whether the Fed will continue or pause in its rate hikes. From May 11 to 23, the Dow fell 540 points, as an uptick in the consumer price index fanned jitters over inflation. Then, on June 2, good news arrived for those hoping for a pause in interest-rate hikes. Nonfarm payrolls rose 75,000 in May, instead of the 180,000 experts had predicted.

Learning to listen
That persuaded many investors that an economic slowdown was in store, justifying a potential Fed break [see BW Online, 6/2/06, "Will May Jobs Report Give Fed Pause?"]. Bernanke's latest remarks, just three days later, put those prognostications in serious doubt and whipsawed investors.

Is the Fed chieftain simply failing his own class on clear messages? Or is he trying to tell the markets they got it wrong again? Some observers theorize that Bernanke intended his most recent tough statement on inflation to be a wake-up call for the bond market.

After all, if inflation fears touch off a bond sell-off and a rise in long-bond rates, those higher rates help put the brakes on the overheating economy — without the Fed having to do the heavy lifting itself.

In time, Bernanke and the markets will learn to hear each other better. For now, the uncertain economic outlook is giving them plenty of reasons to listen closely.