MONETARY policy is fundamentally about coordinating expectations. The extent to which everyone in an economy spends and invests depends upon how everyone thinks everyone else will spend and invest ("if everyone else is spending and investing I will be richer and can therefore afford to spend and invest more!"). Central bankers acknowledge that coordinating expectations is important. That's why central banks now set clear policy targets, and it's why they have mostly prioritised greater transparency and communication in recent decades. But central bankers don't like emphasising the expectations side of things too much, because it makes their task seem much less like engineering or science and much more like psychology or poker. Instead, they like to think of guidance and policy targets as a complement to the mechanical policy tools at their disposal, like their ability to use reserve creation to influence interest rates.

There is a discontinuity in central bank policy when short-run interest rates approach zero. Monetary policy seems to dampen shocks to a much smaller extent when rates are near zero than it does at other times. But why is that? One view is that when rates approach or hit zero the economy enters a liquidity trap and standard monetary policy becomes powerless. Another view is that monetary policy doesn't become powerless but central banks are more concerned about the side-effects of non-standard policy and therefore adopt a less responsive reaction function: it then takes more of a shock to generate a monetary response of a given size.

Another possibility, however, is that when interest rates are above zero, central banks' ambivalence about expectations doesn't matter. Because of central banks' complete confidence in the short-term interest rate tool, there is little doubt that they will keep a responsive hand on the tiller, and that confidence is therefore a powerful expectations-coordinating mechanism. When interest rates fall to zero, however, ambivalence over the power of expectations makes a huge difference.

The Federal Reserve's most recent action has given us a clear example. Fed officials are insistent that when using the balance sheet as an expansionary tool it is the balance sheet's size that matters, rather than its pace of growth. The Fed takes the mechanical view that maintaining a steady rate of asset purchases is highly accommodative; policy is getting easier every month. If the rate of purchases slows, that's still highly accommodative, because the balance sheet is still getting bigger. Even if net purchases shrink to nothing policy has not tightened, because the balance sheet hasn't begun shrinking. From this perspective, the market reaction to last week's meeting of the Federal Open Market Committee (or, for that matter, to the past month's discussion of the schedule for reducing asset purchases) makes no sense at all. The Fed has yet to alter the pace of QE. And yet markets are behaving as if monetary policy has become much, much tighter.

Since late May, when the tapering rumblings first began, the yield on the 10-year Treasury has risen by almost a full percentage point. At the same time, medium-term inflation expectations have sunk by around 60 basis points. Equities are off by 6%. Market reaction has been particularly intense since the conclusion of the FOMC's meeting last Wednesday. Since then stocks have tumbled, the dollar has leapt, and commodity prices have been sinking. These developments also reflect conditions abroad, including China's credit crunch. But conditions abroad (including China's credit crunch) are not independent of the perceived stance of Fed policy.

The thing is, we can dispense with the "as if" and "perceived". The market reaction is tightening. And that tightening is the Fed's doing. It communicated messages last week that markets accurately absorbed and traded into prices. Tim Duy points to this remark, from a press release issued by James Bullard, president of the St Louis Fed, explaining his dissent to the most recent Fed policy statement:

President Bullard felt that the Committee’s decision to authorize the Chairman to make an announcement of an approximate timeline for reducing the pace of asset purchases to zero was a step away from state-contingent monetary policy. President Bullard feels strongly that state-contingent monetary policy is best central bank practice, with clear support both from academic theory and from central bank experience over the last several decades. Policy actions should be undertaken to meet policy objectives, not calendar objectives.

Mr Bullard was more direct in comments to the Washington Post's Wonkblog:

You know, I’ll make a comment about the recent volatility. A lot of people said it’s Fed communication. It wasn’t Fed communication. This was tighter policy. It’s all about tighter policy.

His point is that markets are not swooning because the Fed misspoke but but because it spoke clearly and had unpleasant things to say. As Mr Duy notes, Mr Bullard was there in the room. He knows what the intent of the Fed's move was. The intent, it seems, was to communicate to markets that for a given level of economic activity the economy should expect a less accommodative monetary policy than they previously had. And that, in turn, amounts to a signal to revise expectations lower. Markets did, and the resulting moves in financial markets are both the consequence and transmission mechanism of tighter Fed policy.

The Fed appears to have believed that it could communicate a particular schedule for tapering that was generally tighter than markets had previously presumed, without harming the economy in the here and now thanks to the steady stimulus of ongoing purchases. But that's not how it works. Whatever the Fed does, through interest-rate moves or QE alone or QE in conjunction with interest-rate thresholds, its policy is working by moving expectations in a particular way. The "expectations channel" is always with us. Because markets, households and firms are always trying to anticipate what lies ahead and prepare for it.

I don't know what to expect from the most recent turmoil in financial markets. A sustained rise in real interest rates (including real mortgage rates) alongside a surging dollar and tumbling equities would seem like a very difficult thing for the American economy to shake off, particularly given the headwinds from fiscal tightening. I suspect that the Fed will soon begin signalling, via press reports and speeches, that markets have the Fed all wrong and that they should be behaving as if policy were more dovish. Depending on the content of the message, markets should then level out. That's a good thing; we would all prefer not to replay 1937. But it's frustrating that the message reversal, when it comes, will probably reflect thinking within the Fed that, "markets misinterpreted what we were saying, and so we had to set them straight". That's not what will have happened. Whether the Fed gets it or not, it set a tighter monetary policy last week. And if a new policy message calms markets it will be because the Fed is effectively setting a more accommodative policy than it did on the 19th.

The past few days have made it overwhelmingly clear that the Fed is steering this recovery. That should be comforting; all it has to do is steer things in a more expansionary direction! But it isn't, because the Fed keeps looking around and wondering, who's got the wheel?