Yesterday, the stock market (S&P 500) dropped sharply upon hearing Chairman Bernanke’s testimony before Congress in which he declined to promise that the Fed would engage in another round of quantitative easing as many observers were anticipating. The news sent the market tumbling, and the dollar rose 1% against the euro. Readers of a certain age will recall a well-known advertising slogan for a now defunct stock- brokerage house, E. F. Hutton: when E. F. Hutton talks, people listen. Ben Bernanke is not a stock trader, but when he talks, people do pay attention. By day’s end, however, the market recovered a bit of the ground that it lost immediately after Bernanke’s testimony was released, falling by just half a percent. What happened?
My guess is that the markets may have been factoring in two separate pieces of information. The first was the upward revision in real GDP growth in the fourth quarter of 2011 from 2.8% to 3%. Thus, the market was in positive territory before Bernanke’s testified. The news was reflected in rising real interest rates associated with improving expectations of real GDP growth. The improved expectations of future real GDP growth were countered by Bernanke’s testimony, which suggested that the anticipated easing might not be forthcoming. That sent inflation expectations south, and the market followed inflation expectations, as I have found that it usually has done ever since tight money sent the economy into steep decline in the spring of 2008 when the Fed was mistakenly focused on countering rising energy prices instead of supporting a faltering economy.
The combination of the two effects, the improvement in the real strength of the economy, a positive, was more than offset by the disappointment about the future course of monetary policy. The net effect was a slight fall in prices, but it is interesting to see an example of the two effects going in opposite directions on the same day.
Today the market more than recovered yesterday’s losses, the S&P 500 reaching a new post-crisis high. Real and nominal interest rates both rose, reflecting increasing optimism about economic recovery, and inflation expectations were unchanged. So there are some grounds for cautious optimism, but an oil-price shock could stall this fragile recovery yet again, especially if the inflation hawks on the FOMC have their way, yet again.