What explains the big sell off in markets today? As Ezra Klein notes, many observers are attributing it to the FOMC saying it sees "significant downside risk" to the economy. Felix Salmon, however, objects to this line of reasoning:
It’s silly to think that the decline in stock-market prices was a rational reaction to the FOMC statement. If the FOMC is more pessimistic than the market expected, that’s normally a good sign for markets, since it implies that monetary policy will remain looser for longer. The market cares about the Fed because the Fed controls monetary policy. And so Fed forecasts are important because they help drive that policy. No one revised down their growth expectations as a result of the FOMC statement.
Actually Felix, the decline in equity markets, the drop in treasury yields, and fall in expected inflation all indicate the public has revised down its growth expectations and the most likely reason is Fed policy. Over the past three years the FOMC has effectively kept monetary policy too tight by failing to respond to shocks that have kept current dollar spending (i.e. aggregate demand) depressed. This passive tightening of monetary policy started in mid-2008 and continues to this day. Based on this experience, markets understand that when the Fed downgrades its economic forecast it means the Fed is going to allow things to get worse.
Thus, when the FOMC announced last month that it anticipated keeping its target federal funds rate at exceptionally low levels through mid-2013, it was most likely interpreted as the Fed revising down its economic forecast over the next two years and adjusting accordingly the forecast of its target interest rate over this time to maintain the current (not very stimulative) stance of monetary policy. In other words, the Fed was expecting the natural interest rate to remain depressed longer than previously expected and thus needed to keep its federal funds rate target lower longer than previously expected. The Fed wasn't adding stimulus, but maintaining the status quo as the economic outlook worsened. Such an interpretation was entirely reasonable given the FOMC's failure to fully restore aggregate demand over the past three years.
The question, then, is what can the Fed actually do to change the economic outlook. As I have argued numerous times, the Fed needs to commit to an explicit nominal GDP level target. To do this, the Fed would (1) announce its targeted growth path for NGDP and (2) commit to buying up as many securities as needed to reach it. Knowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its target would cause the market itself to do much of the heavy lifting. That is, the public would adjust their portfolios in anticipation of the Fed buying up more assets and in the process cause current dollar spending to adjust largely on its own. I go into more detail here how this would work, but the key point is the Fed would be better managing nominal spending expectations. No more spooking the markets. Something like it worked for FDR in far more dire circumstances and would most likely work for the Fed today. And, as Scott Sumner argues, had a nominal GDP level target been in place in 2008 it is likely the economic crisis would have been far milder all along.