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Originally published June 20, 2013 at 5:29 PM | Page modified June 20, 2013 at 9:54 PM

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Dow shudders a second day over Fed exit plan

On Wednesday, Federal Reserve Chairman Ben Bernanke took pains to make the Fed’s intentions as clear as possible. In response, investors dumped stocks and bonds over the next two days.

The Associated Press

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WASHINGTON — Wall Street investors wanted clarity from Federal Reserve Chairman Ben Bernanke.

They didn’t like it when they got it.

Bernanke set the record straight Wednesday about the Fed’s bond-buying program. He said the Fed expects to scale back bond purchases later this year and end it entirely by mid-2014 if the economy continues to improve.

In response, investors dumped stocks and bonds in anticipation of rising interest rates — on Wednesday and even more on Thursday.

After dropping 1.4 percent Wednesday, the Dow Jones industrial average was knocked down 2.3 percent more on Thursday to 14,758.32 — its biggest decline since November 2011.

That comes just three weeks after the blue-chip index reached an all-time high of 15,409. The index’s 560-point decline in the past two days wiped out its gains from May and June

The Standard & Poor’s 500 lost 40.74 points Thursday, or 2.5 percent, to 1,588.19. It also reached a record high last month, peaking at 1,669. The Nasdaq composite fell 78.57 points, or 2.3 percent, to 3,364.63.

But the damage wasn’t just in stocks. Bond prices fell, and the yield on the benchmark 10-year Treasury note rose to 2.42 percent Thursday, its highest level since August 2011, although still low by historical standards. Oil and gold also slid.

“People are worried about higher interest rates,” said Robert Pavlik, chief market strategist at Banyan Partners. “Higher rates have the ability to cut across all sectors of the economy.”

The Fed has been buying $85 billion worth of Treasury and mortgage bonds a month since late last year. The purchases pushed long-term rates to historic lows, fueled a record-breaking stock-market rally, encouraged consumers and businesses to borrow and spend and provided a crutch to an economy hobbled by federal tax hikes and spending cuts.

Confusion about the central bank’s intentions set in last month after the Fed released a summary of its April 30-May 1 meeting: Several Fed policymakers said they were open to reducing the bond purchases as early as this week’s meeting.

Bernanke, meanwhile, told Congress that the economy still needed help, but also that the Fed might decide to cut back the bond purchases within “the next few meetings” — earlier than many had assumed.

The conflicting messages left investors bewildered. Just a hint of a pullback in the bond purchases sent bond prices plunging and their yields soaring.

So on Wednesday Bernanke, a former Princeton University professor, took pains to make the Fed’s intentions as clear as possible.

Going beyond the formal statement the Fed’s policy committee released after its two-day meeting this week, the chairman said it would “be appropriate” to reduce the monthly bond purchases later this year and to end them by mid-2014 — if the economy performed as well as the Fed expects.

He said the bond-buying would probably end when the unemployment fell to “the vicinity of 7 percent” from May’s 7.6 percent.

Bernanke explained that the rest of the Fed’s policymaking committee had “deputized” him to expand on what fit “into a terse FOMC statement.”

He said any reductions in bond buying, which keeps long-term rates low, would occur in “measured steps.” And the Fed will remain flexible: If the economy proves weaker than expected, the Fed might decide to restore the higher level of bond purchases to try to drive down long-term rates again.

Plans to reduce the purchases are “very data-dependent, and that’s important,” says Joseph Gagnon, a former Fed official who is now senior fellow at the Peterson Institute for International Economics.

Bernanke likened any pullback in bond purchases to a driver letting up on a gas pedal rather than applying the brakes.

He stressed that even after the Fed ends its bond purchases, it will continue to maintain its vast investment portfolio — which has ballooned to $3.4 trillion — to help keep long-term rates down.

The Fed also said it would keep short-term rates at record lows at least until unemployment slides to 6.5 percent. Bernanke emphasized that 6.5 percent unemployment is a threshold, not a trigger: The Fed might decide to keep its benchmark short-term rate near zero even after unemployment falls that low.

“When we get to that point,” Bernanke said, the Fed will “look at whether an increase in rates is appropriate.”

One factor it will consider is inflation. If inflation falls too far below the Fed’s target of 2 percent, it might decide to keep short-term rates at record lows. The goal would be to fuel more economic growth, which could lead to higher inflation.

Yet markets have been tumbling since Bernanke spoke.

The economists at PNC Financial Services Group said the market sell-off was probably an “overreaction” to Bernanke’s comments. If the Fed scales back its bond purchases, after all, it would mean the economy is strengthening, something that should be good for corporate profits and for stocks.

The Fed faces a tough decision: If the central bank pulls back its stimulus too soon, the U.S. economic recovery could sputter.

If it waits too long, super-low rates could ignite inflation. Or they could swell speculative asset bubbles as investors pursue riskier investments with potentially richer returns than low-yielding bonds.

And if the Fed puts out a confusing message, investors could panic, dump bonds and drive rates high enough to jeopardize economic growth.

“We are determined to be as clear as we can,” Bernanke said at Wednesday’s news conference, “And we hope that you and your listeners and the markets will all be able to follow what we’re saying.”

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