A recent WSJ article discussed two reasons why, unlike in 2013, there was no “taper tantrum” in the markets when the Fed began hinting that they planned to taper their purchase of Treasury bonds:
The benign explanation is that the Fed has done a better job of preparing investors for a shift in its policies than it did in 2013 and that the market largely agrees with its approach. . . . The problematic explanation is that the Fed is going to have to shift its policies more abruptly or aggressively than expected and the market is in for a rude awakening later.
I don’t find either of those explanations to be entirely persuasive (although the first is partly correct.) Indeed I don’t even like the term ‘taper tantrum’, as it suggests that the financial markets behave with the maturity of a baby that had his bottle taken away. These are not “tantrums”; they are rational market responses to new information about Federal Reserve policy.
Unfortunately, many pundits are arrogant, assuming that they know more than the markets. When they cannot explain market reactions to news, they claim investor irrationality. In fact, financial market prices embed far more wisdom than even the most brilliant Nobel Prize winning economist could hope to have. Markets are far smarter than people.
There is a much simpler explanation for the why markets reacted differently this time around. The 2013 decision to taper was a policy mistake that slowed the recovery, as even the Federal Reserve’s leadership now recognizes. Markets understood this immediately. Indeed growing awareness that this was a mistake is one factor that led to the recent adoption of flexible average inflation targeting.
In contrast, the current decision to taper will help the economy. NGDP growth is back on trend, and right now the bigger risk is overshooting, not excessively tight monetary policy. Markets know this and this explains why there has been no “tantrum” this time around. So the WSJ is correct when it points to the fact that this time around, “the market largely agrees with [the Fed’s] approach”.
Many people believe the Fed “pumps money into the stock market”. That’s nonsense; money doesn’t go into markets. Easy money helps the stock market when it helps the economy. A good economy is good for corporate profits. When easy money doesn’t help the economy (as in 1966-81), it also doesn’t help the stock market (in real terms). David Glasner once did a study showing that TIPS spreads became positively correlated with the stock market during the Great Recession, which is roughly the point at which higher inflation expectations would have been beneficial to the economy.
READER COMMENTS
MarkLouis
Nov 4 2021 at 2:08pm
There wasn’t a tantrum because there wasn’t any tightening: inflation expectations are up near the highs and real yields near the lows.
As for the stock market: I don’t think many disagree that there is overlap between what’s good for the stock market and the economy. Where there is disagreement is in magnitude: corporate profits are now a record % of GDP and show no signs of slowing, at the same time that the economy has stagnated for too many.
Yes, the only tool the Fed has is the discount rate. But as it pertains to asset values all a lower discount rate does is pull-forward wealth from future generations to today’s asset-holders. The Fed should consider acknowledging this and, if they need other tools, be at the forefront of that discussion.
Thomas Lee Hutcheson
Nov 5 2021 at 6:38am
A curious remark, “the only tool the Fed has is the discount rate” when the news of the day under discussion was a change in the amount of long term bonds that the Fed is buying.
Scott Sumner
Nov 5 2021 at 5:50pm
You said: “Yes, the only tool the Fed has is the discount rate.”
This is doubly wrong. They have other tools, much more important other tools, and they don’t even have much impact on real interest rates in the long run.
MarkLouis
Nov 6 2021 at 10:38am
Yes the Fed can also buy safe assets. The net effect of which remains the same: lower discount rates and transfer wealth from future generations to today’s asset holders. I have no problem with this as a tool but we’ve taken it to a bizarre extreme: negative real returns on safe assets for an entire generation going forward. There must be better ways.
Scott Sumner
Nov 6 2021 at 2:19pm
That’s wrong; buying assets can just as well cause interest rates to rise due to the Fisher effect. Monetary policy has little or no impact on real interest rates in the long run.
MarkLouis
Nov 6 2021 at 3:00pm
That’s where you and I disagree. Consider a hypothetical counterfactual: the Fed controls the payroll tax as it’s main policy tool. To stimulate it lowers the payroll tax and vice versa (with even a negative payroll tax possible). I believe if that were the case we’d have higher rates and lower asset values for a given level of economic growth. I can’t prove this obviously but you can’t disprove it either.
Asset purchases raise asset values and pull wealth forward from future generations to current asset-holders regardless of any effect on rates. This is a highly undesirable side effect at a time of permanently negative real rates and massive wealth inequality.
Something is causing the lowest rates and highest asset values in human history and the Fed should be leading the discussion about the limits and side effects of its current tools.
David Seltzer
Nov 4 2021 at 6:51pm
“In fact, financial market prices embed far more wisdom than even the most brilliant Nobel Prize winning economist could hope to have. Markets are far smarter than people.” Spot on!
I was a market maker on the CBOE and Amex for many years. Later I managed a small hedge fund. Some observations. I managed risk with the knowledge that the next piece of news could expose me to losses. My alpha as a fund manager was slightly less than zero. We seldom out performed the market simply because we accepted that all market information is impounded in the price of the market. I suspect there will be questions and comments as to why any rational investor wouldn’t just buy and hold.
Spencer Bradley Hall
Nov 4 2021 at 7:32pm
re: “Markets are far smarter than people”
That’s wrong. With the exception of all economists, many people are much smarter than the markets. The markets can be wrong for months. Economists can be wrong forever.
re: “The 2013 decision to taper was a policy mistake that slowed the recovery, as even the Federal Reserve’s leadership now recognizes.”
The FED didn’t taper QE3, 85b in Treasuries per month, until Dec. 2013. Purchases were halted on October 29, 2014. Unfortunately that coincided with the distributed lag effect of long-term monetary flows, a dramatic drop of over 8 points in one month (which caused the “flash crash” in bonds, a “Black Swan” which I predicted).
Joint_Staff_Report_Treasury_10-15-2015.pdf
QE’s end followed the 7.6% and 6.5% quarterly “Percent Change from Preceding Period” in N-gDp. It’s just that the FED’s Ph.Ds. in economics are fatuous.
Spencer Bradley Hall
Nov 5 2021 at 8:44am
re: “Markets are far smarter than people”
Patently absurd. This comes from someone who can’t trade. As as example, Dr. Leland James Pritchard, Ph.D. Economics, Chicago, 1933, M.S. Statistics, Syracuse, in May 1980, predicted the “time bomb” in 1981, the S&L crisis, and the GFC.
Even when the time bomb hit, ratcheting N-gNp to 19.1 percent, the markets didn’t respond for over 3 months. The FED didn’t react for 4 months.
bill
Nov 5 2021 at 9:26pm
What does it mean; tips spreads are positively correlated with the stock market?
Scott Sumner
Nov 6 2021 at 2:20pm
TIPS spreads measure inflation expectations. When NGDP is too low, the economy would benefit from more inflation. That’s why during periods when TIPS spreads went up during the Great Recession, stocks also rose. It was an indicator of more aggregate demand.
rsm
Nov 5 2021 at 11:29pm
《 In fact, financial market prices embed far more wisdom than even the most brilliant Nobel Prize winning economist could hope to have. Markets are far smarter than people.》
Doesn’t every trader know price is a liar?
When traders in 2008 spread emotional panic-selling to assets with no exposure to mortgage defaults, was that rational? Was Hoover right in 1929 to just let markets handle the crash for three years, because prices are efficient? Or was Bernanke right to bid up asset prices using printed money, without considering the Fed’s profit motive?
Was Fischer Black in “Noise” right, markets are efficient only to an (arbitrary) factor of two, 90% of the time?
What are your error margins on prices? Are prices “magically efficient” to you, due to magical thinking that ignores panics and daily emotional over-reactions to rumors on the news?
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