Markets right to take Fed move badly

By Edward Hadas
February 19, 2010

The Federal Reserve deserves some sympathy. The U.S. central bank did everything it could to stage-manage its minimal tightening moves, announced late on Feb. 18. But markets reacted as if to serious bad news.

The changes really are small. The main one was to increase the Fed’s discount rate, which is not currently crucial to the financial system, by a token quarter of a percentage point. That widens the spread between the policy interest rate, currently zero, and the discount rate, which is used for emergency lending to banks, to half a percentage point. Before the crisis, the gap was a full percentage point.

The Fed tried to keep markets calm. It had hinted the move was coming and the press release announcing the changes started by explaining that they were a response to the “continued improvement in financial market conditions”. To hammer the point home, the Fed added that the moves “do not signal any change in the outlook for the economy or for monetary policy”.

If the monetary shifts were as trivial as the Fed claims, then the market response was ridiculous. Stock prices and oil fell by 1 percent or more, while the dollar and U.S. government bond yields rose. Why fly to safety when there is no new danger? If anything, it might seem that investors should welcome small and carefully calibrated moves in the direction of normalcy.

But while investors may have got a little carried away, they are right to consider the beginning of the end of the Fed’s extraordinary measures as bad news for them.

The whole economy has been helped by the ample liquidity support provided by the world’s central banks to counter the financial crisis. But markets have been the greatest beneficiaries. The ample flow of cheap official liquidity has made it possible to bid up the price of all sorts of assets.

The artificial market stimulus is now starting to decline. The pace may be slow, but as the markets’ fuel gets more expensive, they are likely to find the journey bumpier.

Comments

Actually, DJIA and the markets are responding quite disinterestedly at this time. The markets even look bored. Suggest the author pick another topic.

Seen any good movies?

Left Blog.

Posted by reverse_cloud | Report as abusive
 

Mr. Hadas:
Good article. I would recommend to link it though to the U.S. Treasury bonds and explain why these and interest rates are poised to another financial meltdown.

Basic economics: bond prices up, interest rates down and viceversa.

The rates are going up for the sole reason nobody is taking on U.S. debt (the last two bond offerings – 10 and 30 year maturities – sold around a third of the lot). In fact, China are dumping them.

Instead of watching movies, we should keep an eye on the FOMC.

Cheers

AbrahamB

Posted by AbrahamB | Report as abusive
 

No one has any money to retire.

Posted by Anna123 | Report as abusive
 

S&P 500 will remain in the 1050-1120 range it has been in for 8 months because the yo yo of positive and negative headlines won’t stop. I work for http://storyburn.com and we see daily the angst surrounding Americans as they deal with record home foreclosures and job losses.

Posted by muchstardude | Report as abusive
 

it is the end of free money

http://www.investingcontrarian.com

Posted by fresbee | Report as abusive
 

Good article Ed. Your views and articles are very refreshing!

Posted by omidk | Report as abusive
 

Good article as usual! I think the fed wants to reduce cheap fnancing used by banks (it states that the banks should start to look for other sources of financing)to bid up asset prices and somehow get the liquidity into the real economy (small companies, individuals, etc which do not have access to the capital markets). A real challenge…

Posted by OmidK1 | Report as abusive
 

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