Yesterday’s Fed policy statement was a curious one. What could have motivated it?

The choice of words to describe the health of the U.S. economy in the form of “significant downside risks to the economic outlook” is clearly what has sent financial markets reeling in the last 20 hours or so and the curious thing about it is that it is so out of character for the central bank.

They are normally an optimistic lot and, after making clear with QE2 last year that one of their policy goals was higher stock prices, why on earth would they choose this point in time to suddenly express the gravest of concerns for the economy?

It’s not likely that they casually added the words “significant downside risks” to the statement and they must have known what kind of impact they would have.

A look back at the policy statements in mid-2008 – about nine months into the recession that had yet to be declared and leading up to the worst financial market turmoil since the Great Depression – they expressed very little concern about how things were going.

In the Fed policy statement from August 5th, 2008, we got these comforting words:

Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.
…
Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee.

It wasn’t until the day after the Lehman bankruptcy that downside risks were clearly characterized as “significant”, as seen from the September 16th, 2008 statement.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee.

What should one make of this seeming contradiction between then and now?

Well, the Republican’s letter to the Fed Chairman was probably a factor. To what extent, we’ll never know, but, if I were the Chairman of an independent central bank and I got that kind of letter, I’d certainly want to respond in some way.

Maybe, the Fed Chief figured he’d show them a thing or two about who wields the bigger bully pulpit and, if that was the case, then he has certainly succeeded, so far.

Another possibility is that Bernanke figured another massive bond buying program – in the form of a $1+ trillion QE3 program – would ultimately be needed and, given all the political posturing about how unpopular (and unsuccessful) QE2 was, he’d need some pretty big cover to pull that off and a tanking stock market would go a long way in filling that bill.

My guess is that it was a combination of the two.