There's a simple message in what appeared to be conflicting statements from the Federal Reserve, its chairman, Ben Bernanke, and an assortment of other Fed heavies this week about the timing of a move to re-tighten monetary policy.
The messaging is the message. The Fed hasn't made a decision to begin retracting stimulus. Bernanke made that crystal clear when he appeared before a congressional joint economic committee on Wednesday night Australian time. It is, however, actively debating the matter, and saying so.
That means "risk on" volatility is back in the markets, as an undertow to the broader "risk off"currents that have pushed up on asset prices as fears of a renewed global crisis ease. The markets will be more volatile for the rest of the year as a result, and if the Fed does decide to begin withdrawing stimulus, the Australian dollar will fall further, rate cuts will be less likely here and the sharemarket pressure that emerged this week will continue.
The Fed has three options as it tries to help pull America's jobless rate down to 6.5 per cent without igniting medium-term inflation. Unemployment peaked at 10 per cent in October 2009, was down to 7.8 per cent at the end of last year, and is 7.5 per cent now. Inflation is almost supine, at 1.1 per cent in the year to April.
America's jobless rate is still declining. Claims for unemployment benefits fell by 23,000 to 340,000 in the US last week, which was better than expected. They have halved since the peak of the financial crisis and the economic downturn it caused.
The Fed's 6.5 per cent unemployment target makes it clear why it is still talking about its options instead of taking action, however. It took a year and a half to get inflation down by 1 percentage point to 7.5 per cent. There's another percentage point to go before the Fed's target is reached, and when it is, the Fed will want to know that it can be held as monetary policy is tightened.
Option No.1 for the Fed and the markets is the status quo, or at least what has been the status quo until now.
Short-term interest rates continue to be held at close to zero until the unemployment target is secured, and
longer-term rates continue to be held down by quantitative easing - the injection of $US85 billion a month of cash into the economy as the Fed buys government and mortgage debt.
"A premature tightening of monetary policy could lead interest rates to rise temporarily, but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further," Bernanke said at the start of a joint economics hearing on Wednesday.
Option No.2 is the one that got hearts racing after Bernanke addressed the committee, and after minutes of the April 30-May 1 meeting of the Fed's interest rate-setting committee, the Federal Open Market Committee (FOMC), were released. It sees the Fed act earlier and begin to tighten monetary policy before the 6.5 per cent unemployment target is reached, to lower the risk of overcooking the stimulus and reigniting inflation.
Some regional Fed members, including Philadelphia Fed president Charles Plosser and Dallas Fed president Richard Fisher, believe this should happen, and in the question and answer session that followed his testimony, Bernanke said that if the Fed saw "continued improvement" in the economy and was confident it was going to be sustained, "then we could - in the next few meetings - we could take a step down in our pace of purchases".
The market sell-down on Wednesday night and Thursday was basically a response to that statement, and a single sentence in the minutes of the FOMC's meeting 3 weeks ago that were released soon after he spoke.
A "number" of FOMC members had "expressed willingness to adjust the flow of [quantitative easing] purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth", the minutes reported.
In both cases, however, the markets were being selectively paranoid.
Bernanke's attention-grabbing comment that it could be wound back "in the next few meetings" was preceded by an unambiguous statement that the Fed had not yet decided whether such a sustained improvement had occurred.
He also followed his comment about winding QE back by saying that if it did happen, it would not mean the Fed was automatically aiming at a "complete wind-down ... we would be looking beyond that to how the economy evolves, and we could either raise or lower our pace of purchases going forward."
That is option 3: an increase in QE if the economy unexpectedly weakens, and while it is the least likely, the minutes of the FOMC meeting are more balanced than this week's market ructions imply.
Several FOMC members had expressed willingness to begin adjusting the flow of QE as early as June, but "views differed about what evidence would be necessary and the likelihood of that outcome", the minutes reported, adding that the Fed's "willingness" to either boost or reduce QE in response to economic developments needed to be communicated.
The "communication" happened this week. The Fed hasn't decided to cut back QE yet, but it's thinking about it, and it is making sure investors know.