The Fed Launches a Wall Street Roller Coaster

In another highly volatile day on Wall Street, Federal Reserve chairman Ben Bernanke and the central bank’s Federal Open Market Committee (FOMC) took center stage in the drama. Equity markets opened higher after Monday’s punishing 634-point sell-off in the Dow Jones index, but turned down sharply when the Fed announced it would keep interest rates at record lows. In a slap to hopes for a strong recovery, the Fed went so far as to say it would hold rates down for a specific period of time, through mid-2013.

Initially, that glum prognosis sent shares down. However, in the final plot twist of the day, Treasury rates plummeted and stocks enjoyed a powerful rally after a week of declines.

Wharton finance professor Jeremy Siegel said the Fed spooked investors with its grim assessment that the economy is so weak that it would have to hold rates down to near zero levels for two more years. Despite that troubling outlook, the Fed’s decision to effectively declare a two-year hold drove bond rates down so far that investors piled back into stocks, according to Siegel. Stocks had tumbled in the past week following a bitter U.S. debt ceiling debate, concerns over European sovereign debt and Friday night’s Standard & Poor’s downgrade of U.S. debt.

Siegel noted that 10-year; inflation-protected bonds are currently generating unprecedented negative returns. “People are saying, ‘What’s the alternative?’ Stocks are a huge buy right now.”

While the Fed’s decision on long-term rates led to a strong finish for the day in stock markets, Siegel said he has concerns about the central bank’s policy. By prescribing action so far out into the future, he argued, the Fed effectively ties its hands, limiting its ability to respond to new challenges that may emerge. Of course, he adds, the Fed could always reverse direction – the Fed’s statement says only that it is “likely” to keep rates low for that long.

“I think they are going to have to renege on their pledge in the future,” Siegel predicted. While an earlier-than-expected recovery might be viewed as a happy cause for an early Fed policy change, Siegel warned: “I don’t think that’s good for their credibility long term.”

Still, Siegel applauds the Fed board for taking some action, although he noted that three members of the FOMC dissented. Siegel would have preferred that the Fed lower interest rates on reserves or buy long-term securities and sell-short term holdings to reduce long-term rates.

The stock market might have preferred a new program of quantitative easing, Siegel said, but he believes it would have been “premature” for the Fed to take that step only weeks after it completed a $600-billion Treasury bond-buying program.

Despite the dramatic developments that have been driving markets lately, Siegel said today’s gyrations were all about the Fed. “This is the most important thing,” he concluded, “at least for today.”

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