Is the Fed Sending Mixed Signals?

Fed Reserve Chairman Ben Bernanke stood before the House Financial Services Committee to testify on the Semiannual Monetary Policy Report. He was there on a mission–to make it clear to everyone that winding down asset purchases is NOT the same as tightening.

As expected, his speech shook the markets, causing intraday swings on dollar pairs. However, a couple of hours after the event, the dollar returned to its pre-speech levels. What gives?

EUR/USD Chart

Fed sending mixed signals?

If you remember, the last FOMC statement sounded hawkish and pretty much convinced markets that the Fed may soon taper off asset purchases. Big Ben announced that the central bank may decide to start cutting back on stimulus later this year and end QE3 by mid-2014.

However, it seems that Bernanke is backpedaling (or at the very least, softening his claims). He said that the Fed’s asset purchases are not set in stone and could be increased or decreased depending on economic conditions.

Hawkish with asset purchases but dovish with interest rates

On one hand, Bernanke made it clear in his testimony that, yes, the Fed is contemplating scaling back asset purchases. In fact, many still believe that the Fed remains on track to wind down stimulus later this year.

But on the other hand, Bernanke also wanted to clarify that the central bank is by no means in a rush to raise interest rates from its accommodating near-zero levels. After all, an untimely hike in interest rates could undermine the recovery in the housing market, which has finally been gaining steam.

Repeating what he said back on July 11, the Fed head declared that a “highly accommodative monetary policy for the foreseeable future is what’s needed in the U.S. economy.”

It’s all about managing expectations, about striking a balance. The Fed has to use different tools and convey the proper messages to prevent instability in the financial markets.

Bernanke doesn’t want to use aggressive language in fear of driving Treasury yields higher, and he wants to remind everyone the winding down asset purchases is not the same as tightening.

Fed to react to economic data

If there’s one thing that we should take away from Bernanke’s testimony, it’s that the central bank’s future decisions will be based on the strength of the recovery as determined by economic indicators.

This tells us that tier 1 U.S. reports, especially those pertaining to the job market, will most likely continue having a strong impact on dollar trading and should therefore be watched closely. It also suggests that we will probably continue seeing a direct correlation between economic results and the dollar (i.e. positive results = dollar bullish).