Confusion at the Fed or in the market?

Brad DeLong directs us to this analysis of the most recent Federal Reserve policy statement by Barry Ritholz:

What is the Fed Really Thinking?

Last week's rally was ignited by a simple change of phrasing in the FOMC statement. Market took that to mean not only that increases are off the table, but -- Hallelujah! -- a rate cut is in the offing.

Not so fast.

Whenever the Fed says or does something that is subsequently misinterpreted, they have a few back door methods to correct the error. Two in particular were used fairly regularly. Call it the Fed edit/correction methodology.

When John Berry was at the Washington Post, he could be discretely contacted. He's now the Fed columnist at Bloomberg, and while I'm sure he maintains his FOMC contacts, we haven't seen him "break news" like his WaPo days. He primarily does analysis, and he is very insightful as to what the the Fed is thinking. That's quite valuable, but its not the same as "getting the call."

These days, that takes place with the WSJ's Greg Ip. And in a page one article, he lays out what the news is from on high:

"When the Federal Reserve last week altered its post-meeting policy statement to soften the suggestion that it might raise interest rates, Wall Street was confused. Was the Fed signaling that a rate increase was less likely because the outlook for the economy had darkened? Or was it simply reflecting the reality that interest rates are on hold for now? The answer to both questions is, yes."

With no one quoted, and no speech is cited, one has to assume this is straight from the horse's mouth. The WSJ doesn't print factual statements about the Fed on the front page without knowing this is precisely what they are thinking. That's simply not how they roll.

So we can assume that Mr. Ip. is repeating what he was told by very senior Fed Sources. Consider the specifics of the following:

"The Fed is seeing increased risks to its forecast that the nation's economy will grow moderately this year. Those risks include the surprisingly weak level of business investment and the hard-to-predict outcome of the current troubles at the riskier end of the mortgage market. The Fed changed its statement last week to get the flexibility to cut interest rates in coming months if those risks grow. But it is unlikely to use that flexibility anytime soon, because the risks aren't big enough and inflation remains uncomfortably high. (emphasis added)

I'll bet you that the last underlined sentence came verbatim from the Fed. If it was not emailed, than it was spoken slowly and repeated. And the surprisingly weak CapEx chart? Yeah, you can assume that has the Fed nervous.

Here's another classic insider line (and the word "Housekeeping" is classic bureaucracy speak):

"Housekeeping" played a part, as well. For several months, some officials saw the Fed's previous policy statement, which had indicated rates could rise but not fall, as increasingly inconsistent with their own expectations of unchanged rates for the foreseeable future.

We are only to the middle of the article, and we get the conclusion:

The new statement reflects a Fed on hold. It contains no explicit reference to the direction of rates, saying only that "future policy adjustments will depend" on growth and inflation, but reiterates enough inflation concern to indicate lower rates aren't on the table.

The rest of the piece is worth a read, but after this point its just a standard article. All of the prior paragraphs can be considered dictation from the Sermon on the Mount.

What's curious to me is why the markets (Dow Jones gained almost 200 points in the days following the Fed's decision last week to keep interest rates steady) took the Fed's statement to indicate an upcoming interest rate cut. Here's the Fed's press release from last Wednesday:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Recent indicators have been mixed and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters.

Recent readings on core inflation have been somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.

In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

The statement includes subtle changes from the statement after the January meeting in the last three paragraphs.

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters.

Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures.

The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

The Fed now sees the slowdown in growth as continuing because the housing market is not stabilizing as previously thought. The Fed sees inflation remaining a problem, but not as much of a problem as in January. The Fed plans to keep interest rates steady for the foreseeable future, but stands ready to raise them or lower them in response to new information. The new statement is more balanced than January's statement - in the final paragraph, the assessment of risks of higher inflation is toned down some.

I think the interpretation is clear: the Fed is not raising or lowering rates any time soon. They're a bit more pessimistic about growth, but still more concerned about inflation. There is therefore a smaller probability of an interest rate increase in the near future, and a higher probability of a cut, but the best guess is still steady as she goes. So my question is, why did markets misjudge the statement so much as to require the Fed to leak a statement of its true intentions?