This week, Federal Reserve Chairman Ben Bernanke caused huge movements in everything from the Dow Jones Industrial Average (DJINDICES: ^DJI ) to gold. The Fed didn't change policy or raise interest rates, but the mere suggestion that it might slow its $85 billion-per-month bond-buying plan can send shockwaves through the market.
The reaction by the market is both rational and crazy at the same time. Below are two opposite ways to look at Bernanke's words and what they mean to long-term investors.
The view from Bear Mountain
Investors who were sellers this week see the Fed as both an entity keeping the market up and keeping the economy running. The Fed has been buying bonds, which keeps both short-term and long-term interest rates low and bond values high. If the fed slows its $85 billion bond-buying later this year and even ends it next year, it will take a huge buyer out of the market. In theory, losing such a big buyer would cause bonds to fall in value, push interest rates higher, and indirectly have an adverse impact on the stock market.
The end of the Fed's money-printing days also sent gold tumbling this week. Gold bugs have bid up the shiny metal on the theory that added money supply and future inflation will lead to higher gold prices. If the Fed stops printing money, that thesis falls apart -- hence the selling this week.
Beyond the effect of the cash flow on securities, the end of the Fed's bond-buying program could have a detrimental impact on the economy as a whole. The Fed normally uses very short-term Treasuries to control interest rates but has little impact on long-term rates. Lately, it's been buying longer-term bonds in an effort to lower long-term rates. The idea is that this will boost the economy because both businesses and home buyers can borrow at lower rates.
If the Fed ends its bond-buying program, it could lead to higher long-term rates and have a negative impact on the economy.
A good example of the impact of higher rates is a mortgage. For example, a $250,000 mortgage with a 4% interest rate results in a monthly payment of $1,194. If the interest rate rises just 1% to 5%, the monthly payment goes up 12% to $1,342 per month.
Higher interest rates due to reduced Fed bond-buying would mean slower home sales, fewer corporate bond sales, and, hypothetically, a slower economy.
Oh, the humanity
If tapering is so bad for the economy, why would Ben Bernanke and the Fed even consider it? The biggest reason is that they feel the economy is strong enough to stand on its own. Unemployment is falling, GDP is growing despite higher taxes, and now is the time to think about slowing down temporary monetary-stimulus measures.
Bear in mind that Bernanke didn't announce tapering of the Fed's bond-buying program; he simply hinted that it could be coming. He gave himself wiggle room to keep stimulus going if the economy or employment should get worse.
We can think of the economy as a kid learning to ride a bike. Ending monetary stimulus is like taking the training wheels off. The kid will fall, there will be skinned knees, and someone will cry, but at the end of the day that kid will be cruising down the road unassisted. And right now Bernanke is saying that the economy is steady enough for the Fed to consider taking the training wheels off.
In the long term, that's a good thing.
What should investors do now?
Should you buy, sell, or do nothing based on Bernanke's words this week?
At The Motley Fool we're long-term investors, so we see tapering by the Fed as a positive sign for the future of the economy and the stock market. It means employment and the economy are improving, and eventually that will lead to higher profits for the companies we own. Higher interest rates are a drag on those profits, but they're coming eventually, so they're no reason to panic now. Remember how higher taxes were supposed to be a downer for the stock market this year? How did that turn out?
So when the market freaks out, it's time to look for great long-term stocks, get in, and hold on for the ride. This won't be the last time Mr. Market freaks out about something Bernanke says, but the market is really about growth in the economy and corporate profits, not the day-to-day mood of traders on Wall Street. That's why I think the market's down week is a time to buy.