Remember this trick from childhood? Ask someone to pat his head and rub his stomach, and he will inevitably start to rub his head or pat his stomach. One body, two separate actions. Epic confusion.
That's the awkward position the Fed is in right now. It is trying to make changes to its $85 billion-a-month bond-buying program without affecting its promise to keep interest rates low. In theory, the two should be able to move independently of each other. But the market disagrees.
Stocks plunged and bond yields spiked last week when the Fed announced plans to reduce its bond purchases this year and end the program when the unemployment rate hits about 7 percent, which is expected to occur in mid-2014. Part of the panic stems from investors' fears that even a small change brings the Fed that much closer to ending the days of easy money.
In an extended interview with The Washington Post, Minneapolis Fed President Narayana Kocherlakota said that the problem was central bank communication. The Fed has not adequately conveyed the message that the bond purchases and interest rates are not directly connected, he said. That has made the markets unnecessarily anxious about the first reduction in bond-buying.
“The questions about the front end are really questions about the back end," Kocherlakota said in the interview. "We have to be able to break the link between when asset purchases might be reduced and when actually the entire arc of Fed policy, and most importantly with the fed funds rate, how long we’re planning to keep that low.”
Kocherlakota argued that there were two ways to fix the problem. First, he advocated for the 7 percent unemployment rate to be treated as a threshold for ending asset purchases, rather than a hard stop. He said that would give markets more confidence that the Fed would not withdraw its hand too soon.
“There’s a distinction in the clarity of communication or the hardness of the threshold," Kocherlakota said.
He has also pushed for some time to lower the Fed's threshold for raising short-term interest rates from a 6.5 percent unemployment rate to a 5.5 percent rate. That would more clearly delineate the guideposts for bond-buying from those for interest rates, he said.
Kocherlakota characterized the tapering of bond purchases as actually "a very small adjustment in monetary policy" — one that the economy should be able to digest now. Markets, however, are having a much harder time swallowing the news.
“The focus on tapering is a focus o the future of monetary policy,” he said.
Fed Chairman Ben Bernanke tried to deliver a similar message last week about the significance of ending its bond-buying program:
"If the incoming data supports the view that the economy is able to sustain a reasonable cruising speed, we will ease the pressure on the accelerator by gradually reducing the pace of purchases," he said. "However, any need to consider applying the brakes by raising short-term rates is still far in the future."
He didn't have much luck. Stocks ended the week down roughly 3.5 percent and the selloff continued Monday. It seems patting your head and rubbing your stomach isn't any easier as an adult.