Financial Markets and the Fed

Mike Fladlien over at Mikeroeconomics posted a comment to my entry yesterday on the new Term Auction Facility (TAF) announced by the Federal Reserve and other central banks. And while his question doesn't pertain to the TAF, it is a good question. I'll take a stab at answering it.

Mike asked why the stock market would react negatively to the Fed's dropping of the target Fed Fund rates. And by my observation, there are two groups of investors who would drive such an action: those who think the Fed didn't do enough, and those who think the Fed did too much.

The first group is composed of investors/traders who thought the Fed would lower rates by more than 25 basis points. They believe that the primary concern at this juncture is a recession or, at the very least, a significant slowing of the economy. A reduction by more than 25 basis points would stimulate the economy and would make stocks more valuable. Consequently they took positions in stocks based on their expectations. This is what is meant when you hear commentators talk about a move being "priced into the market." When the Fed did not deliver on their expectations, the relative value of their holdings changed, and they sold off their stocks.

The second group is composed of investors/traders who thought the Fed should not lower rates at all, or maybe even should consider raising rates. To this group, the economy seems to be moving along relatively well, and their primary concern is inflation. They see that a lowering of rates is tantamount to faster growth of the money supply, which leads to inflation. In their view, when the Fed lowered rates, it added fuel to the fire which only means the Fed will have to reverse course and begin tightening. The tightening will slow down a growing economy and could cause raise the threat of recession higher.

Now you may ask, what about the group that is somewhere in between? My response is to think of the Goldilocks story; only one party thought things were "just right." And that person was definitely in the minority in a bear environment.

I welcome other views and explanations, especially from people more knowledgeable about the market than I am.