Late-Afternoon Must-Read: Tim Duy: Markets Tumble. How Will the Fed React?

Tim Duy: Markets Tumble. How Will the Fed React?: “The Fed’s decision to taper despite the obvious challenge to their inflation target looks increasingly questionable….

Across the Curve points us to the Wall Street Journal’s anecdotal account of intense pricing pressures (and still weak demand) facing firms…. Despite the Fed’s claim that tapering is not tightening, that it is the stock of assets held, not the flow, that matters, that they could change the policy mix without changing the level of accommodation, market participants are acting as if tapering is indeed tightening…. Bond market participants, who had been starting to get optimistic that improving economic conditions would prompt the Fed to tighten sooner than later are now rethinking that scenario…. If this keeps up, it looks like Yellen will face an early test in her first few weeks as Chair. And I would say there is a good chance this does keep up until the Fed changes direction and decides that the US economy may not have reached escape velocity as believed…. The hawks fought long and hard for the taper; they will not be easily dissuaded from by a few sloppy days on Wall Street….

I sense that the center have something in common with the hawks – the center wants out of asset purchases too, which makes me think the bar to holding asset purchases steady at the next meeting is relatively high. Still, a deflationary shock should make them think twice. Then again, already low inflation should have made them think three or four times before tapering in the first place….

Bottom Line:  The Fed is once again in a familiar place. They try to pull back on policy, and markets tumble. Tightening has repeatedly proved to come too early; one wonders if the Fed would have had to keep doing more if they didn’t keep promising to do less.  If history is any guide, they will eventually reverse course.  But that same history would suggest that they need to see conditions deteriorate further before they act.