Financial Market Confusion and Pessimism Do Not Mean The Fed Is Wrong on Monetary Policy

The financial market reactions to today’s Fed announcement about monetary policy are in line with its responses to Fed comments over the last few weeks – a mix of uncertainty and pessimism. But, market uncertainty and some pessimism are not necessarily good reasons to back away from the policy that the Fed is signaling, which is an eventual reduction in monetary stimulus.

Many commentators have been blaming the Fed for the uncertainty, but this seems mostly unfair. First, the Fed itself does not know how the economy will perform over the next year or two and therefore how it may choose to react over the next few months. The Fed never knows for sure what the economy will get up to, but we are in extremely unusual times, particularly in terms of monetary policy. Second, the Fed needs to be cautious about tying itself to specific targets, since no one statistic or pair of statistics will be accurate enough to pinpoint the state of the economy. We want them to make the right decisions based on the full range of data, not lock themselves into a mistaken choice because overly simplistic measures gave a misleading picture. Third, a substantial part of the uncertainty comes from the markets themselves. We do not know how much investors may have been over-relying on the drug of cheap money to goose their investment performances, either out of greed or fear of failing to hit their return targets. Some of the sharp reaction to Bernanke’s May 22^nd testimony may have reflected investors guessing that other investors would realize they were too far out on a limb and would start cutting back on riskier investments.

Some market pessimism is also justified, for this same reason. The Fed has gotten more optimistic about the economy, which means it is likely to reduce the degree to which it stimulates the financial system more quickly than it would have otherwise done. Cheap money tends to push up financial markets, indeed it is one of the main reasons central banks use stimulus, since the increased willingness of investors to take risks increases economic growth by making it easier for businesses and families to finance investments and consumption.