Explaining the Markets' Reactions to Fed Tightening

Many market participants, as well as Fed officials, are perplexed at the markets' reactions to Fed tightening -- with stocks up and longer-term Treasury yields and the dollar down.  These reactions are the opposite of what traditional theory would imply.   In contrast, my "optimal control" approach to understanding the markets explains what has happened.

The optimal control approach says that markets move in the directions that best achieve the Fed's goals.   With the Fed stating that it aims for slightly above-trend Real GDP growth and 2% inflation, the markets have moved in pro-growth/inflationary directions.  The weaker dollar, in particular, works not only to spur net exports but also to potentially directly lift inflation.

When the Fed tightens -- with the stated aim that it wants to provide room from the zero bound -- the shorter-end of the Treasury curve becomes restrictive of economic activity.   As a result, the markets have moved to offset this restrictiveness, given the Fed's economic goals.  

The markets' reactions will change if the Fed's economic targets change.   In particular, if the Fed becomes concerned about strong growth, the markets will reverse direction -- stocks would fall, longer-term yields rise and dollar strengthen.  This possibility is now unlikely.   Not only is inflation running below the 2% target, but GDP Growth looks to have slowed in Q317.   Both the Atlanta Fed and NY Fed models cut their forecasts of Q317 Real GDP by about 1% point to 2.2% and 1.3%, respectively. As a result, stocks are likely to continue to climb, longer-term yields stay range bound, and the dollar stay soft.