A Morgan Stanley Analyst Nailed The Fed In One Sentence LAST Week

Markets were surprised on Wednesday when the Federal Reserve unexpectedly announced no tapering of its stimulative large-scale asset purchase program, which consists of the monthly purchases of $85 billion worth of Treasury and mortgage-backed securities.

But surprise is part of the deal when it comes to the Fed.

"If FOMC meetings always went as expected, they would not be very important events to markets globally," wrote Morgan Stanley interest rate strategist Matthew Hornbach last Thursday.

And then in one sentence, Hornbach really nailed it:

"The Fed does not pander to market expectations."

Hornbach was addressing how Fed forecasters were employing the idea of "credibility" to predict what the Fed could say in its FOMC statement.

"In the case of tapering, the most common rationale used to explain why the Fed will taper in September deals with Fed credibility," he wrote. "Given the market expects the Fed to taper in September and the Fed has yet to push back in a meaningful way, not tapering would cause investors to lose faith in future Fed communications and create undue volatility. We find this logic flawed"

Hornbach followed up on that point in a research note the next day.

"[W]e do not think that it is a mistake to consider credibility when forecasting Fed policy if credibility is considered in the appropriate way," he said. "If credibility is used inappropriately to argue a point, we think it can mislead investor thinking."

It Was Always About The Economy

Credibility was just one of many non-economic reasons that experts used in their forecasts for a taper.

But, those reasons may have been overemphasized in the incorrect forecasts.

Let's go back and see exactly what Bernanke said when he laid out his roadmap for a tapering. From July 19:

...If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear...

"Gee, it's almost as if the Fed weren't joking when it said the decision would be data-dependent," said BI's Joe Weisenthal after the FOMC announcement.

Indeed it was always about economic data, not non-economic data. And the economists who got it right knew this.

"We see a very close call, with a higher probability of tapering later this year (our base case is December) than at the September meeting," said Bank of America Merrill Lynch's Michael Hanson last Friday who was one of the very few economists to be right.

"While we expect the Fed to taper at one of the next three FOMC meetings, we see good reasons to be patient: recent data have, on balance, underperformed; the Fed needs to reduce its over-optimistic forecasts; and downside risks have re-emerged," he added.

To some extent, many more economists had it right by scaling back their taper expectations to "taper-lite" in light of the deteriorating economic data.

Unfortunately, when it comes to the markets, a little right is often just wrong.