Baby knows best
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.