The paradox of no market response

There seems to be genuine uncertainty about what the Fed will do, or not do, this September.

At a superficial glance, the good news scenario is if the Fed’s decision doesn’t matter much for the markets.  Woe unto you if your economy is so fragile that a quarter point or so in the short rate, mixed in with some cheap talk, were to matter so much.

So if at first prices were to stay steady, following any Fed decision, then equities should jump in price.  That is the “no news is good news” theory, so to speak.  It’s a better state of the world if it is common knowledge that the Fed’s actions don’t matter so much in a particular setting.

What if prices jump right away, following a Fed decision?  The market might then see that price jumps rely on the Fed making good decisions, whatever those might be.  The risk premium might then go up.  It is even possible that prices should on net fall in response to that, but in any case it seems that some further price adjustment is in order, perhaps in the downward direction.  (That ought to come rapidly.)

Most generally, it seems the initial price move, in response to the Fed’s choice, cannot itself be correct, but that first price move must itself induce further price movements.  The price move in response to the Fed’s decision is the economy telling us how much it is relying on the Fed, which right now we do not know.

Maybe the Fed would like to know this too.


It's possible that fluctuations in equity values reflect changes in expected real profits, more than changes in discount rates. Risk premiums have risen, but risk free rates have fallen. If that is the case, the market response won't be immediate. Markets may need to discover over time whether the rate change causes a relative decline in real GDP growth.

An immediate flattening of the yield curve would be a bad sign, though.

How about a very simple analysis that if the Fed decides to raise rates even by a small amount despite there being absolutely no inflation justification then this confirms that future monetary policy will continue to be tight.? I mean even if future data suggests that they should lin fact loosen bureaucratic embarrassment will prevent or slow that. Which would confirm investors bias to remain in low yield government bonds rather than investing in the real economy. At least that's what I will do if the Fed raises rates.

What does it say about the US economy if bureaucratic embarrassment is a significant factor in investment decision making?

My prediction is that regardless of whether the Fed raises rates or not the stock market will drop, at least temporarily, on the news. Half the analysts are predicting raising rates, half are predicting rates stay the same. I'm predicting that half of the analysts will be disappointed.

It says the Fed should do NGDP targeting so they don't have to worry about their own egos getting in the way of the economy

Exactly. They took a discretionary hawkish position the day after Lehman failed when the Fed Funds rate was at 2%, and Dudley recently gave a speech about how 2008 proved that monetary policy sometimes is simply impotent, as if there was nothing that could have been done. The danger here is that if a rate hike does turn out to be slightly wrong, there will be a path dependence to forward Fed policy in spite of that.

And, let's not forget that after holding the Fed Funds rate at 2% and watching the market reaction to that, they proceeded to push the new policy of Interest on Reserves to around 1% until mid-December.

A measly 1/4 point error in September 2008 wouldn't have mattered much if it was made by an institution that would have corrected the mistake over the course of a few days.

But this is a fiat currency nation, so the markets always rely on the Fed. If the markets are swinging at seemingly small Fed signals, then that doesn't indicate MORE reliance. If anything, it suggests that the market thinks that the Fed is on the verge of doing something contractionary relative to the previous interpretion of Fed policy. The market reliance is the same, just de facto accounting with dollars. Volatility reflects the gap between interpretations.

So the Fed is uncertain, the market is uncertain, and professional economists are uncertain. What a fine paradox/conundrum/mess/blog topic.

Tell us again why the Fed is so critical to a sound and prosperous American economy.

The Fed controls the money supply and is therefore critical to the business cycle

I'm amazed that there's no derivatives market on equity prices conditional on fed action.

Isn't that essentially that the options market does?

Someone will have to tell Scott Sumner that now we're supposed to reason from price changes.

"Woe unto you if your economy is so fragile that a quarter point or so in the short rate, mixed in with some cheap talk, were to matter so much."

It is the entire future path of rates that matter. Hike #1 tells us how much weight the Fed puts on it's 2% inflation target in the face of stable sub-2% core inflation. Yellen can say the Fed will go slow all she wants, but if she hikes now few will believe her. The markets will surmise that the Fed will turn the screws as fast as ever. If the markets fall, it's not because the economy is fragile, it's because they think (probably rightly so) that the Fed will repeat the mistake of excessive tightening, heightening the risk of another recession.

Of course we should not ever consider that even with slow growth that a short rate of 1.5 - 2 percent with only 1.5 percent inflation as measured by the Fed is not only out in left field but somewhere near Pluto? Lets keep in mind that real economic growth is not driven by monetary policy -- at best it's just not limited by the policies. A fed rate of 1.05 now would still result in a real rate near zero, which is hardly what one calls tight money.

You can't determine the stance of monetary policy from interest rates. I have no idea why you assume we could get rates to 1.5-2% while keeping 1.5% inflation (which we have not even managed over the last 12 months at 0%). A hike to 1.5% or 2% would probably mean deflation.

This post has convinced me that economists have something meaningful to say about this topic.

At a superficial glance... were to matter so much.

So if ...were to ...then equities should .... so to speak. ...if it is ... matter so much in a particular setting.

What if ...? The market might .... The risk premium might .... It is even possible that prices should ..., but in any case it seems that ..., perhaps in. (That ought to ...)

Most generally, it seems ...cannot itself be correct, but ... must itself induce ....

The market is very uncertain what the Fed is thinking. Otherwise there would be no reaction to the Fed's decision in September--it would have been just as expected.

The market reaction to the Fed's September decision will be mostly because of what it indicates about future Fed decisions. If it raises the funds rate ( without changing the interest on reserves), it will show that the Fed is clueless, and is likely to make more bad decisions in the future.

Yeah, that's not how I see it playing out though. An increase in rates will cement the negative market reaction we have been seeing and accelerate the "flight to quality" we have seen for most of 2015 already, flattening the yield curve as both inflation expectations and real interest rates decline.

All of this will be obvious to the Fed pretty quickly. If they reverse course after a couple months, the damage will be contained. If they dawdle like the ECB did in 2011, the Fed might be able to add another "recession skin" to their already impressive wall.

All of this might take a temporary toll on the real economy, even if the Fed wakes up quickly. A year from now, everyone who is not a lunatic sandwich-board-wearing Austrian will see this for what it is- an unforced error.

The Fed's decisions don't matter much as long as it is common knowledge that the Fed's decisions don't matter much. Sounds like a sort of Confidence Fairy.

"the economy telling us how much it is relying on the Fed, which right now we do not know"

What we do know is that the press is relying on the Fed to inspire many, many speculative stories about what will happen, containing almost no information. Speculative stories are cheap to produce: a few standard introductory remarks, a couple of "experts" quoted in print (or talking heads on TV).

Three steps and a stumble.

That is the old market wisdom that the first one or two rate hikes have essentially no impact on markets.

I would bet that still is the correct assumption.

Maybe the more important question is can the Fed still raise rates. Historically, the bank reserves market was a very, very thin market because banks had no incentive to hold excess reserves. Consequently, it was easy for the Fed to move fed funds. But now that banks are holding very large reserves will it be easy for the Fed to change the fed funds rate? I do not know, but it is certainly an important question.

This post seems to confabulate financial markets with the real economy.

The real economy should be able to absorb 0.5 interest rates.

The financial markets however may currently be propped up significantly by the carry trade. A small interest rate increase could conceivably have very large impacts on the financial markets in terms of pricing of assets while having little direct effect on the real economy.

Unlikely in the short term. The real economy does not seem to favor deflation.

If we do see a reaction, we should be asking why do markets care so much about the future path of Fed policy right now? This has not historically been a strong correlation. Is monetary policy is non-neutral to growth at these conditions, in particular these inflation levels?

It should be relatively obvious that if the economy is telling us it is relying on the Fed to a large extent, this can only mean that we are still in a regime in which growth is being restrained by the tightness of money.

Nearly everyone accepts that (ceteris paribus) if we were in a situation of 10% deflation, there would be a large RGDP/employment benefit to easing, and that if we were at 10% inflation there would be no such benefit. Unfortunately the limits of that relationship and inflation itself are both nebulous enough that we might be relatively deep in either regime and not know it.

Listen to the markets! If the Fed tightens expectations and they shrug, all the better. If not...

TallDave wrote: "we should be asking why do markets care so much about the future path of Fed policy right now?"

Good point! I'll take a slightly different tack - because markets price in some expectation of real stagnation. Under real stagnation, a Fed policy that won't accept a high enough inflation rate will hit the zero bound more often, and if the Fed won't do "enough" at the zero bound then there will be negative consequences in the real economy.

Curious use of a period inside parentheses.

Deciphering the tea leaves . . .

What an interesting issue in terms of possible levels of analysis, and the risks of overthinking a decision. There appear to be few limits to the potential assumptions and points of view about possible expectations that can be offered even by highly-capable experts in macro policy and money and banking. Trying to disentangle one consistent and coherent approach, with definite policy implications, seems like a task that might lead to considerable frustration and ambiguity. That way madness lies?

Here's my alternative formulation. Money is a valuable and productive asset that merits a price in the economy. During most recorded financial history, money has had such a price and modern economies have performed quite well. The monetary policy of the past several years has been a definite anomaly, which requires special justification to continue in light of the long-term financial basics. Certainly the current economy has its problems, but it is hardly so unique as to veto a modest move back in the direction of normality in the capital markets.

Just raise the darn rate, and get on with it!

Complete nonsense. The Fed's mandate is 2% inflation. The Fed itself says it will raise rates only when it sees inflation moving to 2% over the medium term. There is NO reason for the Fed to think that is the case. Market expectations are for under 2% inflation for 30 years! You really think the Fed should abandon its mandate, without giving any guidance as to what its new mandate will be, just because fed funds rates were higher in the past?

Higher and Lower mean different things when at, or close, to zero . . .

does time preference exist?

rhetorical question, obviously

I hadn't realized that even the slightest upward move will amount to the Fed "abandoning its mandate." Please be sure to advise all the others. :)

Does the FED's rate matter for anything at all? Is there any correlation where the FED sets a rate, and only after that the market reacts?

> Woe unto you if your economy is so fragile that a quarter point or so in the short rate, mixed in with some cheap talk, were to matter so much.

Oh, but it is not a small change by any measure. It's a full 3x increase on the interest rate. If banks could carry 1k$ of loans before it, they'll be able to carry only 300$ after the increase.

I'm still not sure that it matters, but people are all taking as if the rate had a linear effect, where by definition it is hyperbolic.

the fed rate is different from what we receive from the local banks . . . ask Bernaki about that

Is the housing market similar to China's data input, in that the government owns the mortgage market and their numbers are similar to what we get from communist governments?

Ask Bernanke . . .

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