Why are markets so surprised by the Fed shift?

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The U.S. Federal Reserve announced this week an upcoming policy shift that just about everyone knew was coming: As the economy heals, stimulus will be withdrawn. But given the tumultuous reaction in the markets on Wednesday and Thursday – followed by an uneasy peace on Friday morning – you have to wonder why the shift has left investors in a state of utter shock.

On Thursday, the Dow Jones industrial average sank more than 350 points, or 2.3 per cent, for its biggest percentage loss since November. The yield on the 10-year U.S. Treasury bond spiked above 2.4 per cent, gold plunged below $1,300 (U.S.) an ounce, European indexes sank about 3 per cent and the CBOE Volatility index (a gauge of investor anxiety) surged 23 per cent.

Add it up, and it looks like the Fed took investors by surprise. Which is surprising.

"Everyone knew this was coming. Everyone knew this was on the table," said Michael Gregory, an economist at BMO Nesbitt Burns Inc.

Fed chairman Ben Bernanke has long made it clear that the central bank's stimulus was designed to bring down unemployment, as part of its mandate.

It has been working: The private sector has been generating about 200,000 jobs a month since the latest round of bond-buying – also known as quantitative easing, or QE – began in September. The unemployment rate has fallen to 7.6 per cent from a high of 10 per cent in 2009.

U.S. economic growth has now been positive for 15 straight quarters, chugging along at a 2.4-per-cent clip in the first quarter. And the long-depressed housing market is now recovering and contributing to overall growth.

"What was true last year, when the Fed started its third round of QE, is not true anymore," said Krishen Rangasamy, an economist at National Bank Financial. "The Fed's stance is entirely warranted."

So why are markets reacting in horror? Mr. Gregory pointed out two reasons why Wednesday's announcement might have caught some investors off-guard.

First, recent U.S. inflation readings have been low, assuaging any concern that stimulus has been stoking price increases.

Indeed, core inflation, which strips out volatile food and energy items, was just 1.7 per cent in May, below the Fed's target of 2 per cent. Stimulus could be necessary to drive inflation higher.

Also, while the U.S. economy has been performing well, the global economy is another matter. In China, a report on Thursday showed factory activity in June had slowed to a nine-month low, raising concerns that the country's economic growth could have an impact elsewhere.

"The market had a bit of hope that maybe we would get a little more ambiguity from the Fed, or a little delay, and we didn't," Mr. Gregory said.

And then there is the view that full-on stimulus is still required to nurse the U.S. economy back to health, and withdrawing stimulus too soon is a mistake that could be difficult to correct. Princeton University professor Paul Krugman, in his New York Times blog, pointed out that employment remains at far from acceptable levels and inflation is too low.

In his view, the Fed needs to signal that it will act unconventionally. By removing stimulus now, it is surrendering that ability.

"I really hope that the real economy recovers at a pace that makes my fears groundless," Mr. Krugman said. "But if it doesn't, I fear that the Fed has just done more damage than it seems to realize."

If so, markets could remain turbulent.

But Mr. Rangasamy argued that a relatively modest correction now is preferable to a bigger downturn later, should ongoing stimulus drive the stock market to unsustainable heights.

"If I had to pick my poison, I'd pick a 10 per cent correction now rather than a 50 per cent correction in two years," he said.