Fed's Minutes Show Risks of Promises

Investors were taken for a ride yesterday by the latest Federal Open Market Committee minutes, which expand on the FOMC’s March 13 statement.

Though the market perceived these minutes to be more hawkish, Federal Reserve Chairman Ben Bernanke has gone out of his way in recent months to assure the market that monetary policy will remain “highly accommodative,” at least through late 2014.

The Fed does have a credibility problem. Having assured investors that rates will remain low for an extended period, it may take only one or two FOMC members turning more optimistic about the economy for the market to price in tighter monetary policy.

Conversely, Bernanke has made it clear that he is most concerned about a recovery in the housing market, and that low interest rates -- throughout the yield curve -- are desirable. Operation Twist is specifically aimed to achieve that by lowering long-term rates and flattening the yield curve. Should investors become increasingly optimistic about economic improvement, they would become more likely to sell bonds, putting upward pressure on long-term rates.

To understand the Fed’s “communication strategy,” one needs to be aware of who is calling the shots. We are not just talking about Bernanke. We are also talking about the voting FOMC members. Without a doubt, the “hawks” (members favoring tighter monetary policy) are getting more vocal. At the same time, the only voting “hawk” on the FOMC this year is Richmond Fed President Jeff Lacker.

The scale may tilt a tad toward the centrist/hawkish side should Congress fill the two vacant seats with the candidates under consideration. Still, when all is said and done, the voting members ultimately determine imminent monetary policy decisions, rather than the noise created by nonvoting members. In our interpretation, those actions remain decisively on the dovish side.

Obviously, should economic data continue to surprise to the upside, the Fed would have an ever more difficult time defending its dovish position. The credibility of the Fed would be seriously tested, because it has committed to keeping rates low until late 2014.

However, should we enter a weak patch, we believe the chances would be rather high for the FOMC to “take out insurance” against another slowdown. In a world where everyone hopes for the best but plans for the worst, central banks around the world, including the Fed, may keep the world awash in money.

(Editor's note: This is an edited and excerpted version of commentary published yesterday by Axel Merk on the Merk Funds Website.)