The Fed is reeling at the violent market response to Bernanke’s statements regarding the eventual taper of Quantitative Easing. High level Fed officials flooded the zone last week, making soothing noises and arguing that the market had overreacted to Bernanke’s words.
There is some solid economic theory that predicts that the public release of “small” pieces of information can lead to big changes in behavior and market outcomes. Specifically, the theory of Global Games (see a variety of paper written by Morris and Shin, in particular) predicts that the release of objectively trivial information can lead to a discontinuous jump from one equilibrium to another in coordination games. The Fed is quite consciously playing a coordination game: it is trying to coordinate the expectations of market participants with the understanding that market outcomes depend quite crucially on consensus beliefs and expectations that tend to be self-fulfilling This is precisely why the market hangs on every Fed statement, every Bernanke utterance. And this is precisely why a seemingly benign public statement with little information content can lead to a big market move. It’s inherent in the game the Fed is playing. They really shouldn’t be all that surprised.
The game the Fed is playing is actually even more complicated than those analyzed in the Global Games literature. Specifically, there is a reflexivity and endogeneity in the Fed expectations game. That is, in the real world game game, the Fed responds to the market’s response to the Fed’s actions, and on and on. That’s not taken into account in the Global Games models, makes things even more complicated, and adds another level of beliefs on which the players of the game (which includes the Fed, prominently) must coordinate.
This is why QE and other exceptional monetary policies are so fraught with danger and risk. This makes chess look like checkers. Mistakes will be made. You will pay for them.
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