Fed bias blues.

Recently Federal Reserve Vice Chairman Donald Kohn appears to have fallen victim to some serious market miscommunication. In the lead-up to the March Federal Open Market Committee meeting, financial markets were full of rumors that the highly regarded former Fed staffer, now Vice Chair, had turned ominously dovish toward the U.S. economy. Rumors maintained that the Vice Chair had informally briefed financial market participants of his deep worries about the U.S. housing market in light of ongoing sub-prime mortgage defaults, as well as the unexpectedly serious decline of capital spending.

When on March 21, the FOMC issued its official statement citing concerns for both the strength of the economy and rising inflationary pressures, the markets initially bet in favor of the Kohn rumor, believing the statement of concern for inflationary worries was mere boilerplate language and that the Fed had actually changed its bias to neutral (from a bias toward inflation concerns). Days later, Federal Reserve Chairman Ben Bernanke stepped in during congressional testimony and changed this dovish misinterpretation, suggesting that the FOMC's bias had indeed not changed at all.

Why markets became so confident of the Kohn rumor remains a mystery because the Vice Chairman's public comments have reflected the more balanced positioning of the Chairman. Yet some market participants continue to insist that Kohn privately was panicked. European Central Bank strategists say they were also aware of such pessimism.