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Bernanke's first listed concern has to do with liquidity. The massive relative size of the Fed's quantitative easings, he said, leads him to worry that the markets in which the Fed operates could take on an administered character. That quality, he worried further, could drive out private trading and, with it, the price discovery and liquidity on which markets rely. He went so far as to state that the lack of a "free-trading" aspect in Treasuries and agencies, to use the chairman's words, could erode the lead these markets have offered in pricing and yield and, therefore, make overall financial markets less efficient, as well as weaken the overall effect of any future Fed policy.
A second concern on the list involves confidence. The chairman worries that the expansion of the Fed's balance sheet will raise doubts about the Fed's ability to adjust monetary policy, in particular its ability to exit from its present, highly accommodative stance. Even if unjustified, Bernanke emphasized, such a loss of confidence could drive up long-term inflation expectations and thwart the Fed's otherwise carefully developed plans to "normalize monetary policy" at some future date. Sadly, he failed to review those plans.
Stability was third on the chairman's risk list. He worries that nontraditional policies, by driving down long-term yields on Treasuries, agencies, and mortgages, will induce investors to make an "imprudent reach for yield" that could in time produce losses and destabilize financial markets. He was quick to point out that the Fed saw no evidence of such a move as yet and that he would actually welcome more risk-taking by investors, at least within reasonable bounds. But he did recognize that the underlying risk exists.
The chairman's fourth and final concern dwelt on the potential for losses in the Fed's now immense security holdings. Since the Fed turns all of its profits over to the Treasury, any such losses would effectively add to the government's budget deficit. Against this concern, Bernanke offered reassurance that the Fed’s purchases actually benefit taxpayers by reducing the federal government's deficit and debt, presumably by holding down the cost of debt servicing. But he acknowledged that keeping down government debt is less important than the Fed's efforts to stimulate the economy and, consequently, the country's living standards.
These four concerns revolve around what Chairman Bernanke referred to as the Fed's "balance sheet tools," but the Fed's new "communications tools" raise a fifth and potentially serious risk. A great potential for heightened volatility lies in the new practice for policymakers to express their longer-term expectations of where interest rates are headed. When the Fed makes an interest rate forecast, it effectively invites all investors to position themselves in a consistent way. Though the Fed qualifies its expectations by explaining that they depend on unfolding economic and financial conditions, the fact is, the public pays scant attention to such qualifications and believes instead in the Fed's special insight and its power to enforce its expectations. As long as matters go as the Fed expects, this near uniform positioning presents little risk. But if unforeseen events force the Fed to deviate from its stated plan, such a common positioning will require the bulk of market participants to adjust, disrupting markets greatly and adding to volatility.
Of course, policy shifts have surprised markets in the past and have been disruptive. But because the Fed previously kept its rate expectations to itself, market participants positioned across a spectrum of possibilities. Some looked for rate increases, some decreases. Some looked for a move sooner, some later. When the Fed adjusted policy, only some market participants needed to adjust. But now, with the Fed offering official expectations, it would take a bold investor indeed to position himself or herself in any way other than the Fed indicated. Any Fed deviation from the stated path, then, would force a much greater proportion of the market than in the past to make portfolio adjustments, bringing on much more disruption and volatility. Unless Chairman Bernanke and his fellow monetary policymakers have acquired an omniscient ability to see the future, this new communications tool could ultimately cause more harm than good.
Nothing in this discussion aims to criticize the Fed's extraordinary efforts to deal with the financial crisis and its aftermath. Even considering all the risks, it is hard to see what choice policymakers had in the extreme circumstances of 2008–09 and have had in the difficult years since. But with this list of risks, it is also apparent that the jury is still out on the ultimate efficacy of these policies. By making his concerns public, Chairman Bernanke has offered a measure of reassurance that the Fed is at least aware of the potential side effects of its powerful policy medicine and stands ready to deal with them. Markets now must see if the Fed can and will execute on these comforting implicit promises.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.