Stockholm syndrome at Fed?

Here are two simple competing views of why the Fed seems to back off raising interest rates when markets react to the prospect.  Figuring out which story, if either, is true will not allow you to get the Fed’s next move or the one after that.  What matters most are the data,*  by which I mean broadly the observed state of the world outside the FOMC. But choosing the right story might help a bit at the margin. It would be one aspect of the Fed’s reaction function.

Story 1

The Fed leadership believes that there is information about the economy and the private sector’s interpretation of the Fed’s intentions in movements of asset prices around Fed news. It also believes that asset prices can directly affect the behavior of the economy. One might say that asset prices are both an unreliable thermometer and a fritzy thermostat, in that regard.  Accordingly, If asset prices react abruptly to news that the Fed is considering a policy move designed to gently tap on the brakes, then the Fed takes that as one possible reason not to tap the brakes.

Story 2

For some reason, maybe the revolving door or the election cycle, the Fed is being held “captive” by the markets and refuses to raise interest rates even if that would help the Fed achieve its objectives for the economy, which are sustainably full employment and price stability, as the Fed defines it.  Before the Fed can raise interest rates, then, it must get permission from its captor. This permission is unlikely to be given, so the Fed will continue with its current policy. This policy is clearly too stimulative, which raises the obvious question why the Fed would sustain it.  Stockholm syndrome helps resolve that puzzle.

No points for guessing that Story 1 is the more likely. I am not going to argue the point, being pretty confident that just presenting the two stories side by side is enough. It is kind of like my case for the non-existence of your God.  Just straightforwardly presenting what the opponents claim to believe is usually enough, I figure.

Really? That’s your story. You believe that? Please say that again. And speak up. I admire your honesty.

And yet you often see arguments that are pretty obviously based on Story 2. I won’t name names because I probably already seem grumpy enough this AM. But I see on Bloomberg this morning a Fed forecaster with a bad habit of being chronically too hawkish saying that the Fed is pulling its “punches” because of fear of the markets. I wonder how that helps his clients.

I would also challenge the premise that the Fed’s job is to beat up the economy by punching it as hard as it can.  But that is a separate discussion, mostly about covering up incompetence with fake machismo and the affinity fraud.  That’s pretty common too.

* Another great source of misplaced whining is that the “data” are the unemployment rate and the CPI and nothing else.  How come the Fed is not following the data, like John Taylor says it should?!