Panic is counterproductive

So: the Fed cut rates by 25 basis points, and the market tanked! (DJIA down 200 points or so, half an hour after the announcement.) Why?

The answer seems to be that the markets had priced in a roughly 55% likelihood of a full 50 bp rate cut. The average funds rate implied by the December Fed funds futures contract was 4.255%. But this represents an average for the whole month of December -- and since we already have 10 days at the old rate of 4.5%, futures market participants apparently thought there was a good chance (55% to be exact) of 50 basis points.

Still, this seems like a disproportionate reaction. In a 2005 paper published in the Journal of Finance, Ben Bernanke and I looked at the stock market's reaction to Fed policy, and found that a 1 percentage point "surprise" policy action was typically associated with a roughly 5% change in the stock market. Today's surprise was quite small in the scheme of things: only 12 basis points or so, which would normally have generated only a 0.6% (82 points on the DJIA) market decline. So today's reaction is unusually large by historical standards. Why?

Good question. Obviously, relationships like the one Bernanke and I fitted, will never fit the data perfectly, and there's no point in trying to come up with an explanation for every outlier. Still, the outsize reaction makes one think: was it something the FOMC said -- or didn't say? (There have been plenty of instances where the Fed's statement, as much as the rate change itself, generated major movements in the market.) Was it the failure to cut the discount rate 50 bp to address mounting liquidity concerns? Maybe. Or perhaps in times of financial stress, Fed actions (particularly unpleasant surprises) simply have larger effects on financial markets than they do during "normal" times. That would be an interesting hypothesis to explore -- but with no more than a handful of observations, any conclusions would be pretty speculative!