Why Did the Fed's Action Shake the Market?

Last week, the Federal Reserve appeared to indicate that it was rather concerned with where the economy was heading. It signaled this through its action to further loosen monetary policy by using cash from maturing assets to purchase longer-term Treasuries. The market was not particularly amused, as the Dow has been down a couple hundred points ever since. Why was the market so shaken?

The Bulls and the Uncertain

First, there are those who are optimistic about the market -- the bulls. Let's pair them with those who are uncertain. These groups of investors were likely disturbed that the Fed appears worried. But Minneapolis Fed President Narayana Kocherlakota think they overreacted. Here's what Kocherlakota said in a speech yesterday:

The F.O.M.C.'s decision has had a larger impact on financial markets than I would have anticipated. My own interpretation is that the F.O.M.C. action led investors to believe that the economic situation in the United States was worse than they, the investors, had imagined. In my view, this reaction is unwarranted. The F.O.M.C.'s decisions were largely predicated on publicly available data about real G.D.P., its various components, unemployment and inflation. I would say that there is no new information about the current state of the economy to be learned from the F.O.M.C.'s actions or its statement.

Indeed, the Fed reviews the same data as other economists and investors. So why should its opinion matter to the market? Well, because it's the Fed.

The market always reacts when the Fed moves. It analyzes -- maybe even overanalyzes -- every word in the monetary policy meeting statements. So of course investors would make a big deal out of actual action and a seeming policy shift. As far as the Fed goes, it was pretty significant.

Even though the Fed was looking at the same economic indicators as market, the central bank itself is an indicator. Its experts are considered some of the most brilliant economists in the world. If they're worried, then this helps provide support for other economists who have let be known their fears of a double dip. When the Fed sides with the bears, the market's fears are confirmed.

So the concern of the two crowds consisting of the bulls and uncertain investors wasn't about the data -- it was about the Fed.

The Bears

This might imply that pessimists -- the bears -- celebrated the Fed's action. To them, the move may indicate that the central bankers are finally coming to their senses and realizing the risk of double dip the bears have been screaming about for months. But many likely weren't satisfied.

In fact, true bears probably were unhappy that the Fed didn't do more. Some wanted to see the Fed re-open its asset purchase programs -- not just prevent its balance sheet from running off. They likely believe more aggressive action is necessary to prevent the economy from sinking back into recession.

So what you get from the Fed's move is a world where pretty much no one is happy. The bulls and uncertain investors are freaked out that the Fed is worried. The bears are annoyed that the central bank isn't doing more. Consequently, stock prices took a hit. We shouldn't be surprised.

(h/t's: Economix & Calculated Risk)