There was a hopeful narrative going into the last week’s Federal Reserve meeting that Fed Chair Jerome Powell and company would emerge more dovish. The stock market’s sell-off this year could frighten the Fed into standing down from its earlier insistence about tightening monetary policy. Not only did Powell stride into the press conference unbowed and undeterred, but also he left no doubt that the Fed is fully committed to being hawkish. As if that stern rebuke was not enough, Powell acknowledged a high degree of uncertainty in the path ahead. The messages helped create a lot of market churn.
The latest Federal Reserve meeting delivered an important tone and message. I reviewed the transcript of the press conference to understand the sources of the market angst. I was (pleasantly) surprised by the complete acknowledgement of an inflation problem. Accordingly, Powell left no question that emergency monetary measures need to end. Powell’s openness to the potential surprises ahead likely unnerved financial markets, but the transparency laid the groundwork for the Fed to act flexibly whether proactively or reactively. Financial markets are embarking on a new journey with Powell and this Fed. The Fed is no longer a friend. The Fed is now the gentle but stern nanny trying to shepherd markets somewhere closer to normalization.
The quotes below come from the transcript. I provide my armchair commentary to highlight the important signals.
The Fed recognizes that inflation is a real problem but still expects it to subside
The Fed blames the pandemic for the lion’s share of the current inflation problem.
“Inflation remains well above our longer-run goal of 2 percent. Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation. In particular, bottlenecks and supply constraints are limiting how quickly production can respond to higher demand in the near term. These problems have been larger and longer lasting than anticipated, exacerbated by waves of the virus.”
Inflationary pressures are spreading beyond direct pandemic effects and causing a new source of concern.
“While the drivers of higher inflation have been predominantly connected to the dislocations caused by the pandemic, price increases have now spread to a broader range of goods and services. Wages have also risen briskly, and we are attentive to the risks that persistent real wage growth in excess of productivity could put upward pressure on inflation.”
The inflationary pressures turned out to be more deeply entrenched than the Fed expected.
“…what we’re learning is it’s just taking much longer [for economic issues to resolve]. So I think — longer than expected. And that I think does raise the risk, that high inflation will be more persistent. “
Having said all that, the Fed wants everyone to remain calm. Inflation expectations are under control.
“Like most forecasters, we continue to expect inflation to decline over the course of the year.”
Hawkish: The economy no longer needs emergency measures
Given inflationary pressures and a strong economy, the Fed is finally ready to remove emergency monetary measures. Almost two years later the Fed is making a u-turn in the hawkish direction.
“In light of the remarkable progress we have seen in the labor market and inflation that is well above our 2 percent longer-run goal, the economy no longer needs sustained high levels of monetary policy support. That is why we are phasing out our asset purchases and why we expect it will soon be appropriate to raise the target range for the federal funds rate.”
Powell later underlined his hawkish tone by reemphasizing the need to step away from emergency monetary measures.
“…now the economy no longer needs this highly accommodative policy that we put in place. So it’s time to stop asset purchases first and then, at the appropriate time, start to shrink the balance sheet. Now, the balance sheet is substantially larger than it needs to be. We’ve identified the end state as — in amounts needed to implement monetary policy efficiently, effectively in the ample reserve regime. So there’s a substantial amount of shrinkage in the balance sheet to be done. That’s going to take some time. We want that process to be orderly and predictable.”
Given the complexity of the balance sheet, the Fed wants to place focus on rate policy. The Fed wants to simplify the messaging to the market about how monetary policy will change.
“…the federal funds rate is our primary means of adjusting monetary policy and that reducing our balance sheet will occur after the process of raising interest rates has begun.”
The outlook for policy includes maximum uncertainty
I strongly suspect one sentence created the most angst for financial markets. During Q&A Powell declined to provide reassurances about the path of monetary policy. He directly acknowledged that a high level of uncertainty surrounds monetary policy.
“…it is not possible to predict with much confidence exactly what path for our policy rate is going to prove appropriate. I stress again that we’ll be humble and nimble. “
The impact of shrinking the balance sheet is another uncertainty that is sure to worry markets going forward.
“I think we have a much better sense, frankly, of how rate increases affect financial conditions and, hence, economic conditions. Balance sheet is still a relatively new thing for the markets and for us, so we’re less certain about that”
Despite the uncertainty about the tightening process, the Fed is pretty sure that substantial work lays ahead. The economy is strong and inflation is hot. Accordingly, tightening could run for longer and move faster than some previously anticipated. I suspect this extra hawkish dose of medicine added yet more angst to financial markets.
“We know that the economy is in a very different place than it was when we began raising rates in 2015. Specifically, the economy is now much stronger. The labor market is far stronger. Inflation is running well above our 2 percent target, much higher than it was at that time. And these differences are likely to have important implications for the appropriate pace of policy adjustments.”
Powell drove the hawkish point home by insisting that employment is so strong that the Fed has a long runway for hiking rates. This point makes plenty of sense relative to a monetary policy still perched at emergency levels.
“I think there’s quite a bit of room to raise interest rates without threatening the labor market. This is, by so many measures, a historically tight labor market, record levels of job openings, of quits. Wages are moving up at the highest pace they have in decades. If you look at surveys of workers, they find jobs plentiful. Look at surveys of companies, they find workers scarce. And all of those readings are at levels really that we haven’t seen in a long time and, in some cases, ever.”
The Fed is counting on markets to price in policy ahead of time
Too many times I hear commentators and pundits bemoan the stock market as being disconnected from the real economy. Too many of them fail to recognize that the stock market cares little about the current economy or private companies for that matter. Market participants are looking ahead and trying to forecast, sometimes even guess, what lies ahead for the economy. They do their best to estimate how that future economy will impact the shares of publicly traded companies. The Federal Reserve is counting on that discounting mechanism to work in its favor.
“…we feel like the communications we have with market participants and with the general public are working and that financial conditions are reflecting in advance the decisions that we make. And monetary policy works significantly through expectations. So that in and of itself is appropriate.”
The Trade with A Hawkish Fed
The simple summary from this Fed meeting: expect volatility. The volatility index (VIX) should remain elevated for quite some time until the stock market can see the light at the end of the monetary tunnel. Unfortunately, zero rates and the massive size of the balance sheet imply that tunnel is quite long. One of the biggest risks going forward is that inflation remains entrenched while the Fed struggles to normalize policy. The resulting economic stagflation would be entirely new territory for the vast majority of market participants. Who knows what can happen then…
Be careful out there!
Full disclosure: no positions