What Markets Missed About Interest Rates

(Dec. 7) -- In economics, timing is everything, which is the real message about interest rates from Federal Reserve Chairman Ben Bernanke's speech Monday, rather than the newly leavened economic forecast many in the markets seemed to hear.

Wall Street was closely watching the Fed chief as he spoke to the private Economic Club in Washington to hear how the Fed is interpreting the recent, less-dire economic news, namely the employment report out Friday that, if not good, was less bad than many economists expected. More than anything else, investors wanted to know how close the Fed is to considering an increase in benchmark interest rates that have been near zero for almost a year.

Bernanke said his "best guess at this point is that we will continue to see modest economic growth next year -- sufficient to bring down the unemployment rate, but at a pace slower than we would like." Yet "on the other hand," he noted, like any good economist, "the economy confronts some formidable headwinds that seem likely to keep the pace of expansion moderate," including the difficult time households, small businesses and other borrowers have getting credit and a job market that remains weak and could still discourage growth in consumer spending.

Interpreting the speech, Bloomberg focused on those "headwinds," and the Wall Street Journal noted the Fed chairman affirmed that interest rates would stay at their historic low "for an extended period," while CNBC said the financial markets heard an "all clear" on monetary policy from Bernanke. The markets gyrated a bit, first on the prospect that the cost of borrowed dollars could rise and then on perceived confirmation that they won't anytime soon. At the end of the day the Dow Jones industrial average ended regular trading up 0.01 percent. The S&P 500 was down 0.25 percent. The dollar, which had strengthened earlier in the day, weakened. And gold prices, which had plummeted earlier in the day, recouped much of their losses.

But Bernanke and his colleagues on the rate-setting Federal Open Market Committee may see more urgency in forming the monetary "exit strategy" he also discussed than many investors think.

Other fronts in the government's economic fight also seem to be at a turning point. President Obama, who is scheduled to give a speech on the economy Tuesday, acknowledged to reporters today that since the Troubled Asset Relief Program -- the crisis measure aimed at stabilizing banks and lending -- has been "cheaper than we had expected." So some of the money Congress allotted for TARP could be used to generate jobs or reduce the budget deficit, he said.

And Bernanke, who like all Fed officials takes care with a bully pulpit markets never ignore, dwelt on the the potential threat of inflation and Fed inflation remedies more than he has in any recent speech. An address last month to the Economic Club in New York focused much more on unemployment as a bigger economic factor, and Bernanke didn't even mention inflation in his opening remarks last week at the Senate Banking Committee's hearing on his renomination.

Though Bernanke did indeed say that "right now" the Federal Open Market Committee is "still looking at the extended period," he said that when it meets again next week committee members will have to try to update their outlook. "Obviously, there've been some signs of strength recently; we'll want to factor that in as we talk about this next week," he said.

Bernanke noted that the scale and scope of the Fed's efforts to pump money into the credit, banking and investment systems has left inflation hawks "uneasy," and suggested the reason he thinks inflation won't be a long-term threat is that the Fed "is committed to keeping inflation low and will be able to do so."

It's that commitment that could be in evidence when the Fed meets next week, and that could shock markets if investors are too confident about the notion of indefinitely cheap lending.

For another subject Bernanke mentioned a few times was inflation expectations -- the self-fulfilling assumptions of businesses and workers that cause them to charge more or demand higher pay, and that are the bane of all central banks. He expressed comfort at how stable inflation expectations currently are. But inflation expectations are never a comfortable subject at the Fed.

Whether the Fed is close to raising rates -- and with economy still ailing and employment still so high, it's not -- it may increasingly feel the need to sound tough, using words as a policy tool even if it isn't ready to take starker measures. If not, the next term the markets could start worrying about is stagflation.