Fed's Kocherlakota: Markets misinterpreted FOMC’s decision

From Minneapolis Fed President Narayana Kocherlakota: Inside the FOMC

The FOMC’s decision has had a larger impact on financial markets than I would have anticipated. My own interpretation is that the FOMC action led investors to believe that the economic situation in the United States was worse than they, the investors, had imagined. In my view, this reaction is unwarranted. The FOMC’s decisions were largely predicated on publicly available data about real GDP, its various components, unemployment, and inflation. I would say that there is no new information about the current state of the economy to be learned from the FOMC’s actions or its statement.

Kocherlakota points out that the Fed's balance sheet was falling quicker than anticipated because of the high level of refinancing as mortgage rates have declined.

But Kocherlakota fails to note that the mortgage rates have declined because of the weaker economy - and the Fed appears to be behind the curve in adjusting their views lower.

Kocherlakota is forecasting that real GDP growth in the 2nd half of 2010 will be about the same as in the first half:

Based on estimates from our Minneapolis forecasting model, I expect GDP growth to be around 2.5 percent in the second half of 2010 and close to 3.0 percent in 2011. There is a recovery under way in the United States, and I expect it to continue.

Although Kocherlakota forecast is possible - and is a weak recovery - I think the economy will slow in the 2nd half.

And I think the growing view isn't that the economy is worse than investors had imagined, but that the Fed is once again behind the curve on the economic outlook.

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Has the market been overreacting to the FOMC's most recent announcement that it will be freezing its balance sheet at current $2.5T by using returns from mortgage-backed securities bought following the collapse of Bear, Lehman and AIG to buy 5- and 10-year treasuries, maintaining its loosy-goosy monetary policy?

Dubbed QE2-lite the FOMC announcement outlined a hybrid of the more radical and oft predicted 'QE2' expansion of the Fed balance sheet, which presumably would have grown to $5T, all in an effort to fight off deflation and unfreeze long-suffering credit markets in the western world. If this sounds like its a 'last-resort' strategy, that's because it is precisely that.

I believe the markets are beginning to prove that the LARGE fundamental underlying problems suffering the international economic and political systems are no longer distant matters for another generation, they are immediate mortal threats to mankind and we are stuck with the current crop of partisan-obsessed talking heads who we all know are bound to fail us terribly whether tomorrow or a year from now..

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