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.