I am at Porcfest–lots of video forthcoming–so perhaps I’m missing nuances here, but my understanding is:
(1) The Fed announced it would scale back its purchases of Treasuries and other assets (depending on the situation) in such a way, as to make the markets think that the Fed was going to tighten sooner than previously thought.
(2) The stock market fell sharply.
(3) Price inflation expectations fell.
(4) Nominal Treasury yields rose.
(5) Real Treasury yields went through the roof (e.g. from June 3 to June 21, the 30-year TIPS yield went from 0.95% to 1.45%).
So the common layman would presumably interpret the above by saying, “Bernanke’s massive money pumping and Treasury buying had been propping up stock and Treasury prices, and raising price inflation expectations. When the Fed announced it was backing off, people expecting less price inflation, and with less of a buyer the price of Treasuries fell (i.e. yields rose). Duh.”
Yet if I’ve understood Scott Sumner and Nick Rowe (not going to look up links right now), this is a very ignorant perspective. It’s wrong to think the Fed pushes up the price of bonds when it buys them; the opposite is the norm. Consequently, people who think there is a cozy relationship between the Fed and the government just don’t know macro.
So this week’s situation should at least throw sand in their gears. When something like this happened in Japan recently, I think they had the decency to admit it puzzled them. And to be fair, Scott has the decency right now to write: “I have no idea why real T-bond yields are soaring—no idea at all. However given the rise in real bond yields, the stock market setback is quite small, indicating that the market doesn’t expect significantly slower growth. That also confuses me.”
In summary, my point isn’t here to say, “Aha! Sumner is a fool.” Rather, my point is to remind the free-market fans of Sumner that his worldview doesn’t “explain everything perfectly since 2008” the way his more energetic supporters like to claim. The allegedly naive commonsense approach–which says the Fed is holding down interest rates right now–also has a lot going for it, in addition to being common sense.
P.S. Recently Krugman did a post where he walked through the permutations of stock, dollar, and bond prices to tell whether the Keynesians or their critics were right, in assessing Fed policy. I don’t have time to go look that up right now, but does Krugman’s analysis–which at the time made him look like a genius of course–show, in light of this week’s events, that the Fed is the bad guy?