Learning to believe in the Fed

Federal Reserve Chairman Jerome Powell


Photo:

Tom Williams / Associated Press

Does Wall Street finally believe in the Federal Reserve? Officials have warned for weeks that the central bank would tighten policy faster than many expected to break inflation. So the tumult among bond and stock traders, after President Jerome Powell repeated the promise on Thursday, comes too late.

Sir. Powell almost confirmed that the Fed will raise its key interest rate by 50 basis points in May, more than the usual 25-point move. Equities and bonds fell immediately, with the S&P 500 falling 1.5% on Thursday and a further 2.8% on Friday, the Nasdaq falling 2.1% and then 2.6% and the 10-year government bond yield rising to 2.917% on Thursday.

Market movements – as the tightening of the Fed has hardly begun – underline the credibility challenge that the central bank has created for itself. Investors were surprised Thursday because they have been conditioned to believe that the Fed will always come through with a bid to support the market.

And who can blame traders? Going back to the Alan Greenspan era, the Fed has acted as if rising asset prices are a measure of its success. Sir. Powell delayed the settlement of pandemic asset purchases during its quantitative easing program, so he would have time to warn investors that change was on the way. A bad market reaction to quantitative easing, the 2013 economic downturn, is living in Fed lore, and markets know the Fed wants to avoid another one.

With the Fed now accelerating the outflow of its QE portfolio, bond markets are rediscovering how to trade without the central bank sitting at the long end. Investors may conclude that managing inflation will require higher interest rates and perhaps some economic pain, if not a recession. Some might call this a route, but we would call it a market signal.

Stocks can also be in for rude surprises. Investors bidding on stock prices for two years now have to contend with the impact of rising stock prices and the danger of lower economic growth for earnings. Oh, and the threat of higher taxes and more burdensome rules from Washington at least until the November election.

The Fed will have to ignore all this as it fights inflation, especially if it hopes to strengthen its credibility. But standing firm can be Mr Powell’s biggest challenge. Market fluctuations are likely to continue and the revaluation of assets could lead to a financial failure or three. Bank balances are more robust than in 2006, and consumers are in better financial shape, but we only know in the end if they are solvent enough. Housing will be a question mark as recent price increases are moderate.

The international context has also rarely been more complex. Europe is on the brink of recession. China’s zero-Covid lockdowns are grunting supply chains. A rapidly declining Japanese yen (now below 128 yen against the dollar) triggers panic in Tokyo over the health of the world’s third largest economy.

Investors need to have more boring rides on the roller coaster while driving out of this economic change. Our advice to Mr. Powell: Let the markets find their new equilibrium on their own. The Fed’s most important task is price stability. The Fed is in this solution because it waited too long to curb inflation and let the markets think they had too much influence on his thinking.

As for investors, it may be time to call your favorite retired bond trader, reminiscent of the challenges of the 1970s and early 80s. The Fed made everyone think those days were over. Retro is back on Wall Street.

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Published in print on April 23, 2022.

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