Investors seem to be particularly antsy of late as the Fed prepares to raise its benchmark interest rate for the first time in nearly a decade—possibly as soon as its September meeting. The rate has been at zero since the darkest days of the financial crisis, and the first increase whenever it comes, will indeed be momentous, closing a chapter in the Fed’s unprecedented experiment in how far it can push the nation’s economy.
Getting the timing and communication of that move right is a challenge for the Fed—and it has bungled the process before. Markets convulsed in 2013 when officials tried to signal that they planned to phase out, or “taper,” the central bank’s bond-buying program, one of the pillars of its stimulus efforts. U.S. stock markets plunged and bond yields skyrocketed. The volatility was dubbed the “Taper Tantrum,” and the Fed mollified markets when it pushed back the phase-out of the program.
Investors have been waiting for round two—Rate Rage—as central bank officials began signaling months ago that an increase in the target rate would likely come before the year is out. This week’s rout coincided with the release of minutes from the Fed’s last meeting, which many analysts pointed to as explanation for the sudden pessimism on Wall Street.
The finger-pointing is misplaced in this case. The minutes gave little indication of the exact timing of a rate increase. Instead, they show Fed officials buoyed by the progress in the job market but puzzling over persistently low inflation. Though the minutes were written the central bank’s typical carefully balanced tone, many investors interpreted them to mean the likelihood of a Fed rate hike in September was falling. Prices on fed funds futures suggested the probability dropped from 45 percent to just 24 percent after the minutes were released, according to CME FedWatch.
But wait a minute. Those who blame the Fed for the stock market slide are often the same ones who believe the central bank is behind the record highs that Wall Street was notching just a few months ago. If easy-money policies have fueled the bull market, then the prospect of a delay in liftoff for interest rates should be reason to rally, not retreat.
In fact, both the Dow and the S&P spiked in the 20 minutes after the details of the Fed’s meeting were released on Wednesday. It wasn’t until the next day that the selloff took hold, and investors casting about for a scapegoat landed once again on the Fed. (Nevermind that in the age of high frequency trading, it seems unlikely that it truly takes Wall Street a full day to “digest” the minutes.)
The other common Fed blame game sees any delay by the central bank as a sign of underlying weakness in the economy—and an evil omen for the markets. The central bank has indeed emphasized that its decision on when to raise its target interest rate will depend on the outlook for the economy.
But the minutes—a recounting of the Fed’s meeting three weeks ago—provided little new information to trigger a market meltdown. And there was actually positive economic news that got lost in the selloff: Existing home sales jumped to their highest level in six years in May, driven in part by first-time buyers.
The final argument is a circular one. Volatility in the markets could make the Fed wary of making a move, which in turn spooks investors even more. This is when the Taper Tantrum is invoked as evidence of how the market can drive the central bank.
That reading, however, is overly simplistic. It wasn’t the plunge in markets that frightened the Fed; it was that the swings were translating into tighter financial conditions in the real economy. Specifically, the selloff in the bond market pushed the yield on the 10-year Treasury up from 1.7 percent in April to close to 3 percent just six months later. Mortgage rates spiked in tandem, and central bank officials worried that the backup could derail the progress in the housing market.
In other words, it was the real economy—not Wall Street—that gave the Fed pause. And this time, bond yields aren’t rising, they’re falling, down from 2.2 to 2 percent over the past two days. Top Fed officials have already accepted that there will be some turbulence in markets ahead of the first rate increase.
So if the central bank isn’t to blame for the rout, what is?