Imperfect Knowledge Economics. Stock Markets and the Fed

The events of last week are an excellent example of the central argument made by Roman Frydman and Michael D. Goldberg in their seminal book “Imperfect Knowledge Economics. Exchange Rates and Risk” (Princeton University Press, 2007).

Monday 21 January the German DAX index closed down more than 7%, the FTSE 100 lost about 5.5% and the CAC 40 almost 7%. Markets in the U.S. were closed because of Martin Luther King Jr. day.

Tuesday 22 January Asian equity markets were sharply down, the Nikkei by 6% and the Hang Seng by almost 9%. Stocks across Europe opened down but recovered during morning trading. Markets in the U.S. looked set to open sharply lower, the Dow Jones by as much as 600 points as implied by the futures market.

But then, at 8:20 a.m. ET, the Fed announced a 75 basis point cut in U.S. interest rates. European markets spiked then fell, then rose again. The DAX ended the day with a loss of 0.3%, the CAC 40 was up 2% and the FTSE 100 was up 2.9%.

The extreme volatility continued on Wednesday with huge intraday swings in individual stocks across the board in both Europe and the U.S.

Then on Thursday the news broke that a rogue trader at French bank Société Générale had caused losses of 5 billion EURO (7.2 billion USD) with trades in European index futures. The previous days there had already been rumors about possible losses at a French bank, but these had been attributed to write-offs in relation to the subprime mortgage crisis in the U.S.

Société Générale informed the French central bank on Sunday. It was agreed that they would first unwind the positions before informing investors. Given the magnitude of the loss the total exposure is estimated to have been about 50 billion EURO. Despite assertions by Société Générale that their trades accounted for no more than 10% of total volume, unwinding these positions may have contributed to the losses in European equity markets on Monday and Tuesday.

Now the question raised by many is whether the Fed knew of the losses at Société Générale when it decided to cut interest rates. According to a Fed spokesperson they didn’t. If this is true, the Fed may have based its decision on imperfect knowledge. It may have interpreted the market decline in Europe on Monday as further evidence for earlier considerations about the state of the economy, when this decline may, in part, have been exacerbated by the Société Générale trades.

According to neo classical economic theory only a surprise interest rate cut will be effective. Rational economic agents act with perfect foresight and so will already have adjusted to an anticipated rate cut. The interest rate cut of Tuesday 22 January was a surprise in both timing and extent. As such it may have been based on economic reasoning. In 2004 Fed chairman Bernanke co-authored a paper, which provided empirical evidence for the effects on stock markets of unanticipated monetary policy actions.

The timing and size of the rate cut actually caused some traders and commentators to suggest the Fed knew something the market didn’t and that the economic outlook was even worse than expected.

Prices in stock markets reflect the last trade at which a bid and ask were matched (only in very rare circumstances the price is a bid or ask price). If you look in a system such as Bloomberg or Reuters during trading hours you can see the price ticks and associated volumes go by in real time.

Thus if a stock suddenly drops by few percent this means that at this new price one person wanted to sell while another wanted to buy. The only way to account for this is by assuming diverging expectations, strategies and portfolios.

Ben S. Bernanke and Kenneth N. Kuttner (2004), What Explains the Stock Market's Reaction to Federal Reserve Policy? Federal Reserve Board, Finance and Economics Discussion Series.

Société Générale’s Sales May Have Incited Market Plunge, The New York Times, January 26, 2008. (You may have to login at the NY Times site to view this article).

Roman Frydman and Michael D. Goldberg (2007), Imperfect Knowledge Economics: Exchange Rates and Risk. Princeton University Press.