When Good News Is Bad News

Federal Reserve Chairman Ben Bernanke was full of good cheer as he stepped in front of the cameras recently to explain why our economic outlook is getting brighter.

From the way the financial markets reacted, you would have thought Bernanke's comments boiled down to "Your dog just got run over by a truck."

U.S. stock markets had their worst two-day stretch in more than a year on the Wednesday and Thursday following Bernanke's talk. Overseas stock markets were hit even harder. But the pain was not confined to stocks. Bond prices fell hard too; so did gold. Oil and other commodities slipped as well. The dollar strengthened, but not to the degree that other prices fell.

This is one of those moments when it is worthwhile to take a deep breath and consider what we know, what we don't know, and what we heard that we did not know before.

Bernanke and the Fed have been telling us for many months that they will begin to tighten the extraordinarily lax monetary environment once there are solid signs that the economy is picking up in a sustainable way. We knew well before Bernanke's speech that the Fed plans to cease its $85 billion in monthly bond purchases once unemployment drops below 6.5 percent (it stands at 7.6 percent now), as long as inflation stays below roughly 2.5 percent in the interim. Inflation is currently running well below that level, at around 1.4 percent. Bernanke has also signaled that the central bank will not begin lifting short-term interest rates, currently near zero, until after it has stopped the bond purchases and other so-called quantitative easing, or QE.

In other words, we will be in the current easy-money environment for quite a while. We knew this before Bernanke spoke. We still knew it afterward.

So what, exactly, did Bernanke tell us? For one thing, that the 6.5 percent threshold for ending QE is not automatic; it is simply a point at which the Federal Open Market Committee will consider ending the program. For another, he told us that weaning the economy off QE is likely to be a gradual process, perhaps beginning when unemployment falls to around 7 percent, but which could be halted or reversed if economic conditions warranted.

Translation: Don't worry. We won't apply the brakes too fast.

But Bernanke's calming message was largely ignored. Observers quickly concluded that the weaning process could begin as early as this fall and that QE might be history before the end of 2014. If this is true, it ought to be good news, since Bernanke's point was that the massive easing will end only if the economy is strong enough to stand on its own.

Financial markets were unwilling to take the chairman at his word. We need to ask ourselves why. I think there are several factors that contribute to the answer.

The first is that financial types mostly respect Bernanke and are not eager to see him go. But President Obama strongly hinted earlier last week, before the Fed meeting, that he has no intention of appointing Bernanke to a third term when his current posting expires next year. Bernanke, the president said, has already stayed "a lot longer than he wanted or he was supposed to." (1) So the president, whose economic savvy is not held in universally high regard on Wall Street (to put it kindly), will pick some unknown party to lead the global economy through the very delicate task of unwinding the current stimulus. Of course the prospect makes people nervous.

Another major factor is that, until Bernanke spoke, the United States looked like an island of relative calm in a particularly stormy world. China found itself in the midst of a financial mini-crisis - at least we can hope it is only a mini-crisis - when its central bank refused to supply the cash that its financial system desperately wanted.

Short-term interbank rates skyrocketed, and there is a growing risk that Chinese enterprises, especially smaller ones, may not be able to get enough capital to finance operations and expansions. Chinese growth was already slowing, and its banking system's coughing fit threatens to slow growth further.

Meanwhile, Europe continues to lag in making structural reforms that might help revive its stagnant economy. Japanese reform plans have also been a recent disappointment. And in the developing world, citizens of Turkey and Brazil have mounted massive demonstrations against their governments despite that fact that, until recently, they were among the feel-good stories of emerging economies.

So there were many reasons for the markets to be edgy when Bernanke spoke. His forthright acknowledgment that change might be on the horizon was just enough to push some people into full-scale panic.

There is one more thing to consider, and that is the hair-trigger mechanism in which many financial instruments are traded these days. Hedge funds and other rapid-fire traders are all eager to be the first ones in and the first ones out when the markets begin to move. A small movement can therefore snowball rapidly, until all the fast-money has raced to wherever it is bound to go next. I think of this as water sloshing in a bowl. Once disturbed, it moves back and forth until the energy dissipates and it finds its new equilibrium.

The simple fact is that the world of zero interest rates and massive central bank lending to the government cannot last forever. At some point, we will have to get from our current, highly abnormal position to a place approximating normal. Last week's panic was bound to happen whenever the first step approached. At least now it is out of the way.

Maybe things will calm down soon; maybe not. In the end, the bad news that the markets thought they heard last week is simply the product of a little bit of good news, which is that we might be getting closer to normal. I'll take that ride, even at the risk of a little motion sickness on the way.

By Larry M. Elkin