WASHINGTON – Stock and bond prices are sinking because investors were caught off guard and alarmed by the Federal Reserve's signal that long-term interest rates are headed higher.
That's the view that emerges from an Associated Press survey of economists late last week. A majority of the more than two dozen economists polled support the Fed's plan to start slowing its bond purchases later this year if the U.S. economy continues to strengthen. Higher long-term rates will likely result.
But in the short run, traders fear that higher rates could slow growth and that the Fed might be moving too fast to slow its stimulus, according to many of the economists. Some also think investors perceived a shift in the Fed's timetable for curtailing its low-rate policies.
The Fed has been buying $85 billion a month in bonds to try to push down long-term borrowing rates to spur spending. On Wednesday, Chairman Ben Bernanke said the Fed will likely slow its bond-buying program later this year and end it next year because the economy is improving. That signal came earlier than some expected.
The Fed has also said it plans to keep its benchmark short-term rate near zero at least until the unemployment rate reaches 6.5 percent. It's now 7.6 percent. On Wednesday, it forecast that unemployment could reach 6.5 percent as early as the end of next year – sooner than previously forecast – and that the economy will grow faster than they thought three months ago.
Bernanke has cautioned that 6.5 percent unemployment is a threshold, not a trigger, for any short-term rate increase. Still, some investors now fear the short-term rate could rise by late next year or in early 2015, sooner than many had assumed.
"It was a big change in tone and messaging," said Mark Zandi, an economist at Moody's Analytics. "Judging by investors' reaction, it was too big a change. The lesson for (the Fed) is to move more incrementally with regard to their communications."
On Monday, one Fed member agreed that the Fed could be clearer about its efforts to help the economy. Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, said he thought the Fed should clarify that it will continue to provide stimulus even as the economy moves closer to healthy levels.
Kocherlakota said in a statement that he thinks the Fed should continue to buy long-term bonds at least until unemployment falls below 7 percent. And he thinks it should keep its short-term rate near zero at least until unemployment reaches 5.5 percent, rather than the Fed's 6.5 percent threshold.
Kocherlakota is not a voting member of the Fed's policy committee this year.
Despite the plunge in financial markets, most economists surveyed by the AP think the Fed got the overall policy right: That the economy should soon be healthy enough to manage without ultra-low long-term rates. The economy has grown at a consistent, if modest, annual pace of about 2 percent the past three years. Employers have added an average of about 180,000 jobs a month over that time, enough to slowly reduce unemployment.
That suggests that the extraordinary support the Fed has provided since the depths of the recession began may soon no longer be necessary, economists said. At the same time, Bernanke has stressed that if the economy weakens, the Fed won't hesitate to step up its bond purchases again.
"The rise in interest rates signals a strengthening economy," said Jerry Webman, chief economist at OppenheimerFunds, said. "If it stays on track ... there would be no reason to maintain an aggressive policy that was designed to deal with a substantially weaker economy."
Some economists argued that continuing the $85-billion-a-month in bond purchases much longer risked inflating dangerous bubbles in stocks, real estate or other assets. As rates have sunk and bond yields have dwindled, many investors have moved money into riskier assets in search of higher returns.
Some said they also feared that maintaining the Fed's pace of bond purchases would trigger higher inflation later. That's because the Fed creates money to pay for its bond-buying program. Too much money pouring into the economy can inflate prices.
"It is important to act sooner rather than later to head off financial excess and the risk of future inflation," said John Ryding, an economist at RDQ Economics.
Still, Michael Hanson, U.S. economist at Bank of America Merrill Lynch, noted that Bernanke hasn't signaled he's alarmed about possible high inflation or asset bubbles. Rather, Bernanke stressed at a news conference Wednesday that the risks of an economic slowdown have declined since fall. He said the economic fundamentals "look a little better."
"I'm skeptical that they would tell us that they're more optimistic while in reality they're actually more worried about bubbles," Hanson said.
The inflation gauge the Fed monitors most closely has risen only 1 percent in the past 12 months. That's well below the Fed's target rate of 2 percent. When inflation falls too low, the Fed normally keeps rates low to try to boost prices.
As a result, some economists surveyed by the AP faulted Bernanke for signaling a likely end to ultra-low rates.
"There is no evidence of inflation anywhere," said Dean Baker, co-director at the Center for Economic Policy and Research. "It is actually falling, not rising. ... This is definitely a wrong-headed move by the Fed."