What are the markets telling us about Fed transparency?

When the Fed makes an important announcement at 2:15, one often sees the DJIA shoot up or down by a few hundred points, and then level off.  This time around the markets didn’t seem to know how to react, sharply gyrating higher, then lower, and then much higher.  This morning stocks are opening much lower.

In one sense the market confusion is easy to understand.  Under normal Fed operating procedures, all the markets need to do is compare the new setting of the fed funds target, with the market forecast 5 minutes before the meeting.  With interest rate targeting no longer operative, the markets must sift through a vague and confusing Fed statement.

But I don’t think that’s the entire problem.  The statement can be read in a couple minutes.  And it’s clear that the promise to hold rates near zero until 2013 was the key decision.  So why wasn’t the market able to quickly find a new support level?

Maybe the decision to hold rates at low levels is itself an ambiguous signal.  After all, low rates could mean easier money, but they could also be an indication of economic weakness, low NGDP growth expectations.

The Fed seems to assume that it can communicate with the markets via the language of IS/LM.  But as Nick Rowe recently showed, it’s not at all clear that the IS-LM model accurately describes the real world.  What if the markets think a different model is more accurate?  Or, more likely, what if the markets don’t know whether IS-LM or quasi-monetarism best describes the real world?  In that case one might expect a great deal of confusion in the markets after a vague promise (forecast?) of low rates as far as the eye can see.  Doesn’t that look like Japan?

What sort of language would the markets understand?  Inflation targeting would be better.  But even that leaves open the question of what the Fed does if it misses its target.  Price level targeting is even more transparent; but which index, core or headline?  Best of all is NGDP targeting, level targeting.  I doubt the markets would have any trouble understanding that language.

PS.  I was interviewed this morning by a California NPR station.  If anyone can find a link, send it to me and I’ll post it.  It went much better than my BBC interview.

PPS.  Nick Rowe’s post is well worth reading.  I do believe he is the only one who really understands IS-LM.  Some people understand what’s right with the model.  I understand what’s wrong with the model.  But Nick understands both sides.  I was slightly disappointed in one respect, however.  The post title promised something a bit more . . . um, erotic.



7 Responses to “What are the markets telling us about Fed transparency?”

  1. Gravatar of johnleemk johnleemk
    10. August 2011 at 06:23

    Matt Yglesias posted a good chart showing how badly the Fed has messed up over the last few years: http://thinkprogress.org/yglesias/2011/08/09/291607/price-expectations/

    There is absolutely zero reason for prices to deviate so far from trend for so long other than a failure of government. People complaining about monetary policy being too loose have their heads in the ground.

  2. Gravatar of Pedro Bento Pedro Bento
    10. August 2011 at 06:30

    NPR link is here:

  3. Gravatar of Pedro Bento Pedro Bento
    10. August 2011 at 06:36

    oops – wrong link

  4. Gravatar of JTapp JTapp
    10. August 2011 at 06:58

    Scott, over 70% of equity trades are algorithmic, just machines and equations. At some point a price trigger was hit, prices moved quickly, and more triggers were hit. I think this explains much of the wave-like volatility.
    A friend in hedging sent me a graph yesterday pointing to evidence that many companies had set a price point for interest rate swaps similar to the one he had set, there was a big jump all at once for no good reason other than a lot of trigger hits at the same time.

  5. Gravatar of Mark C Mark C
    10. August 2011 at 08:24

    I don’t know bout the stock market, perhaps it’s a sigh of relief that though there’s no QE3, at least the Fed seemed to be aware of the seriousness of the situation and would act to keep the economy from going into another recession.

    But if you look at the bond market, the signal was much clearer. Earlier yesterday, when news on Ken Rogoff saying the Fed might do something ‘drastic’ popped up, UST 10yr yield shot up 10 bps to as high as 2.43% and maintained at around that level until FOMC came out with their statement, then ‘bang’ 10yr dropped all the way down to around 2.03% and later closed at 2.25%, 15 bps lower than 2.40%. The bond market was clearly dissapointed (or should I say delighted? since yields going lower would mean profit for bond investors).

  6. Gravatar of flow5 flow5
    10. August 2011 at 09:13

    Monetary policy is too tight. The large revisions to the gDp figures (some going back to 2003), by the BEA (not just the first qtr real-gDp from 1.9 to .4) is all the evidence required.

    Real-gDp peaked in the 3rd qtr of 2007 @ $13,326T. It has failed to reach that level as of this 2nd qtr 2011 (4 years later) – @$13,270.1T

    This is the real reason why stocks suddenly fell sharply & are still falling (not the S&P ratings downgrades, not the end of QE2).

    Targeting nominal gDp is a “revert-to-the-mean” policy. It normalizes any swing outside an expected boundary. It is vastly superior to interest rate targeting as Keynes’ liquidity preference curve is a false doctrine.

    The bottom looks to be Oct.

  7. Gravatar of Scott Sumner Scott Sumner
    10. August 2011 at 17:51

    johnleemk, Yes, that was a good post.

    JTapp, I don’t agree, if so we’d see the volatility all the time. Most Fed announcements are not followed by wild swings.

    Mark C. Thanks, that’s the sort of information that is really informative.

    flow5, I agree about NGDP being too low.

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