“On the surface, you would have thought that the stock market would have liked the outcome of the Federal Reserve meeting; and you would have expected that front-end interest rates would have been relatively well anchored. Instead, equities sold off while the yield curve flattened as a result of a selloff in shorter maturities.
Why?
In attempting to answer this question, let us start with a quick summary of what the Federal Open Market Committee decided at the end of its two-day meeting:
* As expected, our central bankers continued to taper their experimental purchases of securities, reducing the pace of monthly purchases by another $10 billion. They remain on track to exit quantitative easing fully by the end of the year.
(Read more: Fed tapers, backs away from unemployment target)
* To compensate, they strengthened their forward policy guidance in two ways: by replacing the increasingly outmoded and partial 6.5-percent unemployment threshold with a more holistic approach to the labor market; and by making explicit an inflation indicator that is above the current rate.
* They reiterated their intention to keep policy rates floored for quite a while, even after inflation and unemployment are near their “mandated levels.” During her press conference, Janet Yellen stated that the FOMC could keep interest rates lower than “normal values” and that the glide path would be shallower.
(Read more: What’s new in the latest Fed statement)
By any measure, this is quite a dovish outcome — overall and relative to expectations. Unambiguously it signals a Fed that remains dedicated to support the economy, and to do so by continuing to use the asset market channel.
So why didn’t markets like it? I would suggest three inter-related possibilities:
Higher uncertainty premiums: The Fed is in the midst of not one but two policy transitions. It is pivoting from reliance on a direct instrument (QE purchases of securities in the marketplace) to an indirect one (forward policy guidance to convince others to devote their balance sheets) — thereby raising effectiveness questions. It is also moving from a readily-observable unemployment threshold to a set of indicators that include qualitative judgments — thereby raising less predictable interpretation questions….”
