Investors and the Fed: An Intricate Waltz

Fed-watching is a complicated process. The stock market wants the Fed to be vigilant enough about inflation to keep the bond market happy, but not so vigilant that it hits the brakes on the economy so hard that growth slows significantly. Bond traders want the Fed to act pre-emptively against inflation if there are real signs of it on the horizon, but not so pre-emptively that it would suggest that inflation is already here (in which case owning bonds is a bad thing). And the Fed itself needs to send the right message to the markets, which means it needs some sense of how they will react. Oh, and the Fed also has to figure out whether inflation really is on the horizon, and if it is, what course of action is appropriate.

Today provided an especially illuminating instance of the complexity of Fed-watching, because nearly everyone watching either did know or should have known what the Fed would do. Last Friday’s consumer price index number was a surprisingly high 0.7 percent, and even if you factored out energy and food costs (which are especially volatile), the so-called core rate was 0.4 percent, which was way beyond anyone’s reasonable estimates. Now, there are reasons–which seem good to me, but I’m easily convinced about this stuff–to suspect that last month’s spike was an aberration, the product of hikes in clothing costs and lodging costs that aren’t likely to be duplicated any time soon. But given how hot this economy has been running, and how unusual it is to have a sustained period of high economic growth without inflation, the CPI number spooked the bond market, which drove interest rates up as high as they’ve been in a couple of years.

As a result, the Fed had little choice but to do what it did, which was hold the federal funds rate unchanged while announcing that it had “adopted a bias toward tightening.” Raising interest rates at this point would have been jumping the gun, given that labor productivity is soaring, wage pressures remain low, and new housing starts just fell. And certainly the stock market was utterly unprepared for a rate hike. (Not that Greenspan necessarily cares about the irrationally exuberant, but still …) Adopting the bias reassured bond traders that the Fed was aware of potential inflationary pressures, and that it wouldn’t wait to act if they accelerated, while also giving the economy continued room to breathe.

What’s interesting about what happened today is that the Fed’s decision was both reasonably predictable and predictably reasonable, and yet the stock market, at least, couldn’t figure out what it thought about the decision. Early in the day, stocks were up, then they tumbled, then rallied before the Fed’s 2:15 announcement. When the news hit the wires, the Dow plummeted more than 100 points (“plummeted” is overstating the case, with the Dow at 10,900, but you know what I mean) but then crept back almost into positive territory by the end of the day.

If there’s anything perplexing about that series of events, it’s that initial sell-off. The stock market doesn’t like to see the federal funds rate jump (a jump that the bias adoption seemed to make more probable), but at this point everybody should understand that a little Greenspanian fine tuning doesn’t really hurt anything. In any case, adopting the bias doesn’t really tell us much about what the Fed will do next. (Historically, there’s almost no correlation between the adoption of a bias and the Fed’s eventual course of action.) And if the Fed hadn’t pacified the bond market, bonds would likely have sold off, driving up yields and making stocks less attractive as investments.

Still, what today’s market action really points up is just how complex the relationship between interest rates, bond prices, and stock prices really is. Investors want growth but not growth that’s too fast. They want consumer prices that are not rising but not falling, either. And they want interest rates that are low, but not so low that they spark a speculative credit boom. Is it that surprising that, wanting all these things, investors have a hard time figuring out right away what “adopting a bias toward tightening” really means for them?