Fed officials should be careful what they wish for. Echoing some of his colleagues' recent pronouncements, US Federal Reserve Chairman Ben Bernanke on Thursday said the central bank stood ready to tighten monetary policy once economic recovery took hold and head off price pressures.
It was nothing he had not said before, but the timing of the statement, which coincided with a 14-month low in the US dollar and a weak 30-year bond auction, triggered a substantial bout of selling in the Treasury market. Whether this was the Fed chief's intention, only he knows. What is clear is that investors seem ready to embrace signs of economic recovery and begin pricing in eventual interest rate hikes by the monetary authorities.
The problem is that efforts by Fed officials to jawbone inflation expectations lower, such as talk about exit strategies, run the risk of putting upward pressure on borrowing costs and endangering the recovery they hope for. Eurodollar futures contracts from 2010 onward suffered their biggest one-day loss in more than seven weeks. Rates on the benchmark 10-year note surged 11 basis points in just a day. Central bankers could pay a high price for this reassessment. Part of the reason for the economic optimism that has propelled stocks to their highs for the year was a sense the country's housing mess might finally be settling down.
And yet it had been doing so in part because of the Fed's ultra-low interest rate policy, which has been supercharged by outright purchases of Treasury and mortgage-backed securities. With no data to confirm or deny the prospect of a robust economic expansion in the coming week, traders are likely to pay increasingly close attention to what a slew of Fed officials, including vice-chairman Donald Kohn and the New York Fed's William Dudley, have to say about policy.