El-Erian: Why Wall Street initially misread Janet Yellen
FORTUNE — Headlines about Janet Yellen are less about substance and more about short-term miscommunication between the Fed and markets.
“Yellen Debut Rattles Markets” is just one of the headlines that suggested that Janet Yellen, the new chair of the Federal Reserve, made some surprising policy announcement at her first press conference this week. Quite a different conclusion emerges, however, if you listen to the entire content of the event and if you read the accompanying policy statement.
So, what’s really going on?
Taken as a whole, Wednesday’s Fed communication confirms that the institution is steadfastly dedicated to maintaining its exceptional support for the real economy and Main Street. Moreover, due to its narrow set of policy tools — Congress has better ones but is paralyzed by polarization and dysfunction — the Fed has no choice but to bolster equities (and Wall Street) as a way of pursuing its growth and employment objectives.
Yellen emphasized this strongly in her press conference. Whether in stating that unemployment remains too high or that interest rates would be kept abnormally low for quite a while, her message was clear: The economy still requires extraordinary Fed support to overcome the horrid legacy of the global financial crisis. She and her Fed colleagues are committed to provide it.
In delivering this message, Yellen did what most economists do (and what many have been asking the Fed to do more of): She supplied additional information on what lies behind the Federal Reserve’s thinking.
This is particularly welcoming given the extent to which the economy has consistently deviated in recent years from many analysts’ predictions, including those at the Federal Reserve. It is also consistent with Yellen’s well-regarded emphasis on greater transparency.
Traders’ inclinations are understandably different from economists, as are their modes of operation and comfort zones. Most importantly, they are trained to react quickly to outliers, and do so on partial information. Needless to say, the immediate amplification can be quite notable. (It also can die down quite quickly thereafter.)
What captivated traders most during Wednesday’s press conference is not the totality of Yellen’s remarks; nor was it the carefully crafted policy statement of the Federal Open Market Committee.
Traders were also quick to dismiss her assurances that the information content of the statement dominates the arithmetic aggregation of the individual “dot” projections provided before the meeting by each of the FOMC members.
Instead of all this, they latched on to a single remark by Yellen and over-extrapolated the dots.
By focusing on the partial rather than the whole, the stock market ended up embarking on quite a round-trip. The Dow lost over 200 points at one stage on Wednesday, only to gain over 100 points the next day. Traders’ and some pundits’ interpretation of Yellen’s remarks seem to have experienced a similar roller coaster.
Beyond the monetized P&L effect, few were impacted by this stock market volatility. Yet the phenomenon is a reminder of something that can be, and has proven, particularly relevant during intense periods of crisis management.
The scope for communication mishaps between markets and policymakers is still significant. Fortunately, the resulting loss of translation doesn’t matter most of the time as the wider repercussions are limited. During a crisis, however, miscommunication episodes can have material consequences on the well-being of many.
This week’s little flurry is a reminder that greater transparency is about much more than the provision of more comprehensive information. It is also about its proper internalization. It seems that there is still more to do on both counts.
Mohamed A. El-Erian, former CEO and co-CIO of PIMCO, is a member of the International Executive Committee at Allianz and chief economic advisor to its management board, chair of the President’s Global Development Council, and author of the NYT/WSJ bestseller When Markets Collide. Follow him on Twitter