A bit of an unpleasant day in the stock market. Not unpleasant enough, however, to send much of a panic among Federal Reserve policy makers. In fact, quite the opposite – my sense is that Powell & Co. will be happier if the pace of equity gains moderated. Indeed, I would say that this is a lesser-mentioned goal of the tightening campaign. From their perspective, taking some of the steam off the stock market occasionally reduces the risk that financial instabilities grow and become a potential economic threat.
I wouldn’t panic yet either; I don’t think this is the beginning of the end for this bull market. What would be the beginning of the end? When the Fed starts to believe they can’t cut rates in the face of economic weakness due to inflationary pressures. We aren’t there yet.
Both the Dow and the S&P500 were down more than 3% Tuesday. The story floating around the press was that this was a risk-off day as equity traders processed the implications of evolving Fed policy. In contrast, Treasury bonds barely budged; long bonds even fell a notch, lifting long rates. My interpretation is that fixed income traders had already processed the shifting policy environment; equity traders were a bit late to the party.
What is that changing environment? Well, as I have documented over the past several weeks, the Fed has been slowly phasing out forward guidance, leaving market participants a bit more uncertain about the path of rates going forward. I think the Fed views this uncertainty as a policy feature, not a bug. Recall the criticism the Bernanke’s Fed contributed to market complacency by laying out so clearly the rate path. Powell may very well share that criticism (a good question for the December press conference).
The Fed has focused attention away from r-star estimates (and forward guidance in general) to their forecasts instead. And therein lies the problem for market participants. The incoming data appears to confirm the forecast, policy makers appear to agree that the data confirms the forecast. That rate forecast is hawkish relative to market expectations that the Fed would soon pause in their rate hike campaign. Worst, that forecast suggests they keep hiking even after the impact of fiscal stimulus starts to wane. The upshot is that we need to incorporate both a higher path of rates and additional uncertainty about the path of rates into prices. On net, that should sap the equity markets of some strength.
The Fed is not going to ride to the rescue here. There is no Powell-put for a 3% decline. Or even an extended decline like earlier this year. And Bloomberg caught this from New York Federal Reserve President John Williams last night:
“The primary driver of us raising interest rates is just the fact that the U.S. economy is doing so well in terms of our goals,” Williams said Wednesday in a reply to questions after a speech in Bali, where the annual meetings of the International Monetary Fund and World Bank are taking place. “But I would also add that the normalization of monetary policy in terms of interest rates does have an added benefit in terms of financial risks.”
“A very-low interest-rate environment for a long time does, at least in some dimension, probably add to financial risks, or risk-taking, reach for yield, things like that,” he said. “Normalization of the monetary policy, I think, has the added benefit of reducing somewhat, on the margin, some of the risk of imbalances in financial markets.”
This is not new. Federal Reserve Chairman Jerome Powell has made similar statements. There is a widespread concern that persistently low interest rates would become a problem not for price inflation, but for financial stability. Reducing financial accommodation to minimize those risks is clearly a policy goal here.
To add some additional drama to the day, President Donald Trump tossed in his two cents on monetary policy:
“The Fed is making a mistake,” he told reporters on Wednesday as he arrived in Pennsylvania for a campaign rally. “They’re so tight. I think the Fed has gone crazy.”
Trump is setting the stage to blame the Fed should the economy tank. Luckily, I don’t think that’s about to happen. It is important to remember that the Fed’s rate forecast will only hold in a solid economic environment that is generally supportive of equities. If the economy tilts downward more quickly than expected, the Fed will reel back on those rate forecasts. They might hem and haw before they shift, but most likely they will shift. If the economy faces a clear economic challenge, the Powell put will become a reality.
There are, however, two caveats to this prediction. One is just straight-up policy error, misreading the data. The second caveat, which is what concerns me, is that the Fed reaches a point where they don’t think they can ease due to inflationary pressures. As a general rule, central bankers think that inflation expectations are sufficiently well contained that they can maintain a gradual path of rate hikes. I think this also means that they will be react to a substantial change in the economic outlook – a greater slowdown than they anticipate – with a shift toward a more dovish policy path. But there of course is a chance that inflationary pressures emerge such that they think they need to defend their inflation target. In my opinion, in such a circumstance they will choose recession over inflation.
Bottom Line: Don’t panic. Yet. The Fed’s rate path might be higher and more uncertain than anticipated, but this largely reflects a more positive economic outlook. That’s ultimately a good thing. Watch the inflation numbers. Inflation is what could sour the Fed’s plan and its willingness to respond to a substantial deterioration in the outlook.