06/20/2013 10:49 am ET Updated Aug 20, 2013

The Fed Provides 'Forward Guidance' on the Taper and May Be, Once Again, Too Optimistic

Federal Reserve chairman Ben Bernanke did not say anything Wednesday about taking away the famous punch bowl. He didn't even say that he and his Fed colleagues, who've been pouring $85 billion per month of punch into that much expanded bowl, were going to start to slow down the juice flow.

He said that when the party heats up to a particular point-when the unemployment rate falls to around 7 percent, that's when they'll stop the flow. Again, to be clear -- that's not the point at which they'll end the party, which in this overstretched analogy means when they begin to raise interest rates (that will have to wait for 6.5 percent unemployment, as per earlier announcements) or unwind their balance sheet (start selling bonds back into the market). For now and for the near term, the punch bowl will still be there and even growing, though if the jobless rates starts heading towards seven, it will be growing more slowly.

And yet... the markets were not amused. Nor calmed. The Dow tanked almost 200 points before starting to come back a bit.

I've commented in numerous places about the skittish market reactions to what one might have thought forward-looking types would expect. As the day follows the night, key sectors (e.g., housing) correct, the economy improves, the Fed pares back, interest rates go up.

Perhaps market participants think the Fed is once again too rosy in their economic scenario. I agree. Without exception, they've had to dial back every one of their forecasts. So the fact that they now think unemployment will hit 6.5 percent (party over!) at the end of 2014 could be spooking some participants, but if they're once again wrong about this, then based on their guidance, they'll leave rates alone. So why all the angst?

Clearly, markets are having trouble pricing in what happens next, despite what I'd say is historically very clear guidance from the Fed.

But putting all that aside, what I don't get is why Bernanke and company think everything's going along as well as all that. They're discounting the very low inflation we've seen ("transitory influences" was the explanation in their statement). They noted fiscal headwinds as well, but the statements and Bernanke's comments lead me to believe the following:

The Fed is feeling better about the economy because they perceive it to be on steadier footing than at any time since the crash. As noted above, corrections in housing and consumers' and businesses' balance sheets are solidly underway if not completed. Firms are profitable and well positioned to invest in new projects if such opportunities come along.

But as I see it, there's an important difference between steady-footing and actually getting up and running ahead. Bin Appelbaum in the NYT:

The Fed's forecasts have consistently overestimated the strength of the economic recovery since the end of the recession. The central bank has suspended its stimulus efforts twice in recent years, only to find that it needed to do more. Officials have said that they are eager to avoid repeating those mistakes. But there is growing optimism inside the central bank that the Fed is finally doing enough.


But the economic damage of the recession remains largely unrepaired. Job growth is basically just keeping pace with population growth. The share of American adults with jobs has not increased in three years. At the same time, the Fed's preferred measure of inflation has sagged to an annual pace 1.05 percent, the lowest level in more than 50 years, as the economy continues to operate below capacity.

It true that the Fed has to look ahead, to see around the next economic corner in ways that gadflies like I do not. But if every forecast I made proved to be too optimistic, and for all its improvement, the economy was still a slog for millions of un- and underemployed workers whose paychecks have barely kept pace with even weak inflation... well, I think I be a hefty tad more cautious about changing my position as per that punch bowl.

This post originally appeared at Jared Bernstein's On The Economy blog.