WP_Post Object
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    [ID] => 3963
    [post_author] => 28821
    [post_date] => 2007-12-01 04:43:21
    [post_date_gmt] => 2007-12-01 03:43:21
    [post_content] => As the US economy is facing a significant risk of recession —the consequence of the ongoing housing downturn, the persistent credit crisis and the high oil prices—, the Federal Reserve (Fed) appears as the main possible defense against that risk. Such is the confidence of financial markets in its healing abilities (“in Fed they trust”), that its first policy reaction to present economic threats —a 0.5 percentage points (pp) cut in its reference rate on September 18— was received with great relieve and the main stock exchange indexes recovered from previous losses and ended up reaching new ceilings. Of course, there is some rationale in this behavior: almost nobody expected such a large move and lower central bank rates mean lower rates for the whole economy, thus more favorable financing conditions and a higher present value of future corporate earnings. However, it is not easy to understand how the recognition by the Fed of higher economic risks  can end up leading to higher share prices than those reached before the threats were evident. But this one is not the only puzzle in the relationship between the Fed and financial markets.


As the credit crisis revealed deeper roots than previously thought and economic indicators insisted in moving downwards, share indexes lost again around 10% of their values and the Fed, who had already added a less powerful  0,25 pp rate cut in October, has come back to the stage this week, thereby boosting up shares again. With a new cut? No, just with the implicit recognition that there may be a new cut in next policy meeting, on December 11. Well, was this new future action unexpected? No, the futures market was expecting it. In fact, the markets have been recently anticipating progressively declining policy rates, from the present 4.50% down to less than 3.5% and this has not significantly changed after the new Fed hint. So what did the announcement change? Just the explicit Fed position. Since the October move, the Fed had been showing a neutral policy bias, which means no clear intention to touch rates very soon and no clear idea about the direction of the next action. So there are two mysteries in one: 1) why equity prices reacted to something that was already expected by the fixed income markets and 2) how is it possible that normally faithful markets were not believing what Fed was saying.

The previous questions point at another puzzle: the somehow diverging behaviors of fixed income and equity markets. The expectation of below-3.50% policy rates, which could mean real rates lower than 1%, is coherent with a recessionary scenario. At the same time, main equity indexes are not much more than 5% under their recent ceilings, which is not precisely what one would expect from such a cloudy outlook.

Could we find some answers?


    [post_title] => The Federal Reserve and financial markets: curious relationships
    [post_excerpt] => 

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    [post_name] => the_federal_res
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    [post_modified] => 2023-12-13 13:42:56
    [post_modified_gmt] => 2023-12-13 12:42:56
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As the US economy is facing a significant risk of recession —the consequence of the ongoing housing downturn, the persistent credit crisis and the high oil prices—, the Federal Reserve (Fed) appears as the main possible defense against that risk. Such is the confidence of financial markets in its healing abilities (“in Fed they trust”), that its first policy reaction to present economic threats —a 0.5 percentage points (pp) cut in its reference rate on September 18— was received with great relieve and the main stock exchange indexes recovered from previous losses and ended up reaching new ceilings. Of course, there is some rationale in this behavior: almost nobody expected such a large move and lower central bank rates mean lower rates for the whole economy, thus more favorable financing conditions and a higher present value of future corporate earnings. However, it is not easy to understand how the recognition by the Fed of higher economic risks can end up leading to higher share prices than those reached before the threats were evident. But this one is not the only puzzle in the relationship between the Fed and financial markets.

As the credit crisis revealed deeper roots than previously thought and economic indicators insisted in moving downwards, share indexes lost again around 10% of their values and the Fed, who had already added a less powerful 0,25 pp rate cut in October, has come back to the stage this week, thereby boosting up shares again. With a new cut? No, just with the implicit recognition that there may be a new cut in next policy meeting, on December 11. Well, was this new future action unexpected? No, the futures market was expecting it. In fact, the markets have been recently anticipating progressively declining policy rates, from the present 4.50% down to less than 3.5% and this has not significantly changed after the new Fed hint. So what did the announcement change? Just the explicit Fed position. Since the October move, the Fed had been showing a neutral policy bias, which means no clear intention to touch rates very soon and no clear idea about the direction of the next action. So there are two mysteries in one: 1) why equity prices reacted to something that was already expected by the fixed income markets and 2) how is it possible that normally faithful markets were not believing what Fed was saying.

The previous questions point at another puzzle: the somehow diverging behaviors of fixed income and equity markets. The expectation of below-3.50% policy rates, which could mean real rates lower than 1%, is coherent with a recessionary scenario. At the same time, main equity indexes are not much more than 5% under their recent ceilings, which is not precisely what one would expect from such a cloudy outlook.

Could we find some answers?