If you get the impression that the stock market is some sort of paranoid neurotic, overreacting to every little whispered rumor and half truth, you’re not alone. I don’t mean to cast aspersions on the emotional maturity of stock traders, but rather simply to note that there is a whole bunch of money at stake every minute and nanosecond that securities are being traded. So while an average person may find the intermittent pronouncements and releases from the Federal Reserve an inscrutable bore, the stock market looks at them as vital opportunities to make money, or at least to avoid losing it.
And the stock market yesterday was none too pleased with the minutes of January’s Fed policy meeting, which were released yesterday afternoon: The S&P 500 fell 1.2% yesterday and is headed down again today.
What caused the reaction? The concern wasn’t that the Fed would soon back off keeping short term interest rates near zero, or that it expected inflation to rise above 2.5%, or that it was going to scale back its $85 billion per month in bond purchases. The minutes merely said that “many,” or “a number of” Fed officials were concerned that the Fed’s stimulus actions may be dangerously inflating asset bubbles or putting the economy at risk of destabilizing inflation, and that these factors may cause the Fed to pull back on bond purchases before substantial improvement in the economy occurred.
The minutes also, however, noted that many participants were equally concerned about ending purchases too early, and that pulling back too soon could have disastrous effects for economic growth and employment. Ultimately, the market was probably reacting to the uncertainty implicit in the apparent conflict at the Fed. The minutes don’t indicate how many FOMC members were voicing concerns about policy, but actual voting on Fed policy lately has been near unanimous, with only Kansas City Fed Chief Esther George dissenting last time around.
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This near-unanimity is one reason not to expect any serious changes in Fed policy soon. Another is the man heading up the Federal Reserve, Ben Bernanke, who has proven two things in the past year: 1) that he is intent on using creative and aggressive monetary policy to help the economic recovery; and 2) that he is willing to tolerate dissent in order to further the policies he sees fit. Even if a couple more Fed Governors were to join the dissenting side in the coming year, nothing Bernanke has done in his two terms so far as Fed Chair has shown that he would be cowed by this disagreement in and of itself.
In addition, the Fed has reputational issues to consider. It was only late last year that the central bank modified its language on asset purchases and interest rates, pegging future policy to observable data like the unemployment rate, and it’s unlikely that Bernanke would be willing to compromise the reliability of the Fed’s promises by changing course so quickly.
Of course, there were outs built into the Fed’s language. If the economy improves more quickly than expected, the Fed could pair back stimulus more quickly than it had originally promised. In addition, if expected inflation creeps up above 2.5%, the Fed could change course without damaging the market’s trust in its promises. But both of those scenarios appear unlikely, as the federal government appears likely to introduce growth-slowing austerity measures this year through budget mechanisms. And with so much slack in the economy, most estimates of future inflation fall below the Fed’s long-run target.
But again, the markets can be a prickly pear. And interest rates have a direct effect on asset valuation. So any sign that rates may rise will cause some in the market to take cover.