On Wednesday, the chairman of the Federal Reserve announced that the greatest experiment in the history of central banking might be nearing its end. Ben Bernanke’s announcement included many caveats, but the financial markets did not miss the message. Since 2009, the central bank has been buying financial assets – US Treasury bonds and some types of corporate debt – paid for by an expansion of the monetary base (so-called “printing money”). This kept interest rates low, which damaged savers but helped indebted businesses and households. It has also been the major prop for financial markets. Within about a year, if the Fed’s plans come to fruition, the US government deficit will need to be financed from private sector savings – not by the central bank. Asset markets will be left to fend for themselves as the biggest buyer withdraws from the arena.
That is why some hedge funds sold off bonds this week, causing a big drop in their prices – the flipside of which is a rise in borrowing costs (or “yields”). Mr Bernanke has expressed consternation that adjustments to the path for the Fed’s balance sheet, such as the one he announced this week, can have such a profound effect on the bond market. But investors are making logical inferences from central bank behaviour. The Fed does not change direction often. When it does, tightening often comes in a rapid series of interest rate rises that are not fully anticipated by investors.