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Posted: 10-Aug-2011
Today (Tuesday) the stock market jumped up 429 points after plunging more than 600 points the day before (Monday). The jump happened after Bernanke said that he would keep the interest rate low for two years.
"The (FOMC) Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013."
Does this have something to do with the jump in the stock market?
If so, then it must be related to its impact on the level of risk in the economy which has been characterized by increasing risk aversion, particularly after the downgrade. Probably, the two- year break of low interest rates has given investors some kind of certainty that had cut through the thickness of the risk prevailing in the economy. This time limit is an implicit commitment on part of the Fed to keep nominal interest rates at zero for a definite longer time. This commitment in turn should give rise to increased commitments on part of investors and decision-makers who hate uncertainty. There are leading monetary economists who have placed big faith in the Fed's "commitment" as an effective tool to pull the economy out of liquidity trap in which the American has settled since 2008 [1].
Bernanke may also want the investors to move higher in terms of risk maturity. This means moving here up the yield curve and other longer time maturities that include stock market. For example, the Fed and investors could sell five year Treasure notes to purchase 10 year T bonds. This maturity swap an reduce long term interest rates which are relevant for long term investments.
The next few days will show if this interpretation of what Bernanke said and what the stock market did on Tuesday has any credibility. If the market continues to plunge, it just explains that the markets have entered a new era of high volatility and Bernanke’s statement of commitment did not shave off any layers of the accumulated high risk and uncertainty. It may also indicate that the U.S. market is influenced by outside risk (e.g., Euro debt risk) of which Bernanke has no control.
[1] “Monetary Policy When the Nominal Short-Term Interest Rate is Zero”. http://www.federalreserve.gov/pubs/feds/2000/200051/200051pap.pdf
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