COLUMN-If the Fed has to choose, markets could get a lot uglier: Mike Dolan
Band Mike Dolan
LONDON, May 20 (Reuters) – If the US Federal Reserve were to take its policy example at face value and just focus on getting inflation back in its box, the already struggling financial markets could get much uglier and investors seem unprepared for that. .
While the decision is never so clear to Fed policymakers with dual price stability and full employment mandates, there is no doubt that the Fed and other Western central banks are under enormous public pressure to give priority in controlling the worst cut in the cost of living in 40 years.
That could change if or when the recession finally bites – but central banks are likely to see ultra-tight labor markets both give them time to go to hell for leather now and be a good reason to do it.
Moreover, Fed Chairman Jerome Powell openly admitted this week that “pain” could be unavoidable as the central bank pushes back inflation because it lacks the “precision tools” to engineer a soft landing.
Kansas City Fed Chief Esther George made it clear on Thursday that tighter financial conditions were part of the plan rather than an unfortunate, unintended consequence, with falling stocks being “one of the avenues.”
“Where I focus on when ‘enough is enough’ is looking at our inflation target,” she told CNBC, nodding at an inflation rate more than four times this 2% target and now above that target for over a year now and counting.
And yet investors still suspect the Fed will balk at an early sign of economic or financial distress – with futures now seeing a spike in the prevailing federal funds rate target from 1% to just 3% by next March, given an expected reduction in the balance sheet in the Context.
Assuming we get another much-signaled half-point rate hike next month, then this price structure implies a fairly smooth trajectory with an average hike of a quarter-point at each subsequent policy meeting until March – then stopping just half a point above the pre-pandemic period of the peaks in 2019.
Additionally, the terminal rate implied next year fell nearly half a point this month amid choppy markets and rumors of a recession.
This month’s Global Fund Manager Survey by Bank of America (BofA) showed an extremely bearish but also slightly confused and hesitant picture among investors.
While the funds have already accumulated liquidity at the highest levels since the dot.com and September 11 shocks, BofA said they had not reached “full capitulation” as they expect further interest rate hikes.
But respondents also saw hawkish central banks as the biggest risk to financial stability. Even though Wall St stock indexes have already fallen around 20% from highs, funds don’t expect the Fed’s fabled “put” – or policy pivot to appease turbulent markets – emerges without another drop of more than 10% from here.
It doesn’t sound like an investor community that has already priced everything.
SHADOWS AND FOG
What if the markets still underestimated the Fed’s willingness to tolerate some pain while bringing inflation back to its target?
Fed watchers reasonably debate economic, political, and even behavioral factors affecting future policymaking and judge accordingly. There’s probably no way of knowing right now, because so much has to unfold and nothing is set in stone.
But so-called quantitative analysis can also be instructive in sketching out the magnitude of what may be to come, by comparing current political parameters with what we know of the past.
Earlier this year, Solomon Tadesse of Societe Generale (SG) explained how a generally growth-sensitive Fed would be forced to manage the combined tightening of policy rates and a relatively modest $1.8 trillion balance sheet reduction.
Modeling a so-called shadow federal funds rate that captures both effects – which allows comparisons with historical inflation episodes that did not include the buying or selling of bonds – the analysis concluded that if the The Fed was keen to avoid recession at all costs and allow some inflation so the Fed rate peak could be as little as half a point above the current 1%.
This was based on the assumption that the Fed shadow rate was indeed -5% at its trough due to the outsized impact of bond purchases and is still negative even after two hikes and before the so-called quantitative tightening comes into effect.
Tadesse, however, took the model back this week and instead calculated the numbers based on a different assumption – that the Fed is now prioritizing getting inflation back on target, even at the cost of a hard landing. This approach would be closer to the approach taken by the Paul Volcker-led Fed in the 1980s and would ring with growing political pressure to do so now.
The result makes reading uncomfortable for financial markets.
Tadesse estimates that this position would require a sharp overall monetary tightening of 9.25 percentage points in the shadow rate modeled – including a terminal rate as high as 4.5% and a nearly halving of the Fed’s balance sheet by 3, $9 trillion, based on the assumption that every $100 billion in balance sheet equates to about 12 basis points of tightening.
These are of course two extremes and the reality is often somewhere in between – where the markets currently reside.
But the Fed may now have to choose or risk falling between the stools, leaving markets at a crossroads.
“Such a middle course, plausible due to (shifting) political pressures or a mid-term reversal of policy priorities between price stability and full employment, would likely fail to fulfill either mandate. and could harm the central bank’s credibility,” the SG analyst concluded.
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The author is Finance and Markets Editor at Reuters News. All opinions expressed here are his own.
Fed trajectory and marketshttps://tmsnrt.rs/3loZqMf
SocGen chart on combined Fed tighteninghttps://tmsnrt.rs/3yO8B0W
Bank of America May survey of top investor fearshttps://tmsnrt.rs/3wqLSX5
(by Mike Dolan, Twitter: @reutersMikeD Editing by Mark Potter)
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.