NEW YORK (CNN/Money) -
In the wake of another head-scratching Federal Reserve policy pronouncement, Wall Street was abuzz again Thursday with a long-running debate: Is the Fed dumb, or crazy like a fox?
The question of whether the nation's central bank is a bumbling Inspector Clouseau or a cunning Lieutenant Columbo isn't just an amusing parlor game -- the future course of interest rates, including home mortgage rates, hinges on the answer.
On Wednesday afternoon, Fed policy makers, as expected, left their target for a key short-term interest rate unchanged at the lowest level in more than 40 years.
But they stunned stock and bond markets by unexpectedly changing the language of their announcement, dropping a months-long promise to keep rates low for a "considerable period" and replacing it with a promise to be "patient" when raising interest rates.
The markets, which finally thought they had the Fed figured out after some muddled communication shifts by the central bank last year, reacted immediately. And it wasn't pretty -- stocks posted their biggest one-day drop since October, and bonds sold off in a frenzy that drove yields, which move in the opposite direction of prices, higher.
From Wednesday's intra-day low of 4.03 percent, the interest rate on the 10-year Treasury note, closely tied to U.S. home mortgage rates, jumped to 4.20 percent in Thursday morning trading.
"There was always going to be some shock value when the Fed changed 'the considerable period' statement, but we had always felt that the change would come when it was fairly obvious that it should, and when the Fed had softened the blow, by alerting the market to such a change," said Alan Ruskin, research director at 4CAST Ltd., a market and economics research firm. "As it was, there was no such warning, and the sharp market reaction is testimony to just how far it caught asset markets 'off-side.'"
No big deal?
At first blush, the appropriate reaction to the Fed's move would seem to be to give one of those goofy sitcom shrugs and say "Oh, you dumb old Fed! There you go again."
"The savage market reaction is unlikely to be what the Fed had in mind when it pushed the 'send' button at 2.15 p.m. ET [on Wednesday]," said Rory Robertson, interest-rate strategist at Macquarie Equities. "Indeed, it's probably a little shocked. If that is indeed the case, this episode will go down as another unfortunate accident in Fed communication."
Robertson and some other analysts believe the Fed was simply trying to say the same thing it has been saying for months, but in a different way. It was widely reported that some Fed officials had long hated the phrase "considerable period," as it seemed to say that policy makers were bound by the calendar, rather than by the actual strength or weakness of the economy.
According to this theory, "patient" is just another way of saying "considerable period," only without creepy old Father Time leering over your shoulder.
"It's the same meat, but with a different gravy," said former Fed economist Lara Rhame, now senior economist at Brown Brothers Harriman. "The real guts of the Fed's statement is very much unchanged."
And the minutes of the Fed's Dec. 9 policy meeting suggest this was their intention.
"A number of members argued that its deletion would serve to enhance the Committee's flexibility to adjust monetary policy at a later date when that was deemed appropriate on the basis of evolving economic circumstances ... as opposed to having it appear to be linked only to the passage of time," the minutes said.
In a perverse sense, then, if you want interest rates to stay super-low for a long time, then you'd better hope that the Fed is simply incompetent when it comes to communication.
Of course, people who've been happily engaged in the carry trade -- borrowing money at short-term rates to buy long-term bonds -- aren't too thrilled with the confusion. And some economists worry the Fed's fumbling will keep the bond market volatile, just as it was late last year, when the Fed was making other unexpected and unpopular decisions.
"This has been a fundamental problem with the Fed's whole approach to policy making," said Ethan Harris, chief economist at Lehman Brothers. "By changing their language so frequently, they make it impossible to figure out what they're doing."
In the Fed's defense
Other economists, however, believe it's very clear what the Fed is doing -- getting ready to raise interest rates later this year.
"From our standpoint, the change in language represents a small step toward an eventual rate hike," said Morgan Stanley economist David Greenlaw.
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There was no warning from the Fed simply because there was no way the Fed could offer such a warning without triggering a similar market reaction -- any way it did it, the reaction was going to be ugly.
In fact, the Fed's statement may have been the very warning shot traders wanted.
"Fed officials ... likely anticipated some fallout in fixed income markets," UBS chief economist Maury Harris wrote in a research note. "We believe ... that Fed officials wanted to signal a greater probability of tightening in 2004 than had been priced into markets."
What's more, by promising patience and taking note of an iffy labor market and sluggish inflation, they made it clear that the next rate hike isn't just around the corner and could be small, when it comes.
And with the Fed's key interest rate at the lowest level in more than 40 years, some economists believe that simply adding a quarter or half of a percentage point here or there will still leave rates at historically low levels, putting the economy at little risk of a slowdown.
"With the Fed's statement, Chairman Alan Greenspan's famed gradualism is surfacing again, as the chairman appears to be signaling a slow pace of interest rate hikes in the future," said Tony Crescenzi, bond market strategist at Miller Tabak & Co.
"This shows tremendous sensitivity to the markets, as it offers a reason to not be too fearful about the prospect of rate hikes, which were inevitable anyway," Crescenzi added.