The reports we have been receiving of persistently high inflation mean that the Federal Reserve will almost certainly raise interest rates further and keep them there for a long time.
But erratic inflation isn’t the only thing likely to spur the Fed into further rate hikes.
Good news in the financial markets could do the same.
That may seem perverse.
After all, soaring prices at the grocery store or at the pump are bad news for almost anyone dependent on a paycheck or annuity, income from an individual retirement account or 401(k), or Social Security. It’s easy to see why the Fed would want to take action.
But the Fed doesn’t have many tools at its disposal in the fight against inflation. Short-term interest rate hikes are the strongest, and if a steady diet of rising interest rates is really necessary to quell runaway inflation, then we may have to deal with the consequences.
Still, despite the Fed’s efforts, markets have been remarkably buoyant for much of the past few months. Why should this good financial news worry the Fed? Basically because positive financial news – also known as “easing financial conditions” – could prevent the Fed’s rate hikes from having any effect in fighting inflation.
Good news
Positive financial news includes a number of developments. A stock market rally, a rise in bond prices, or a drop in mortgage rates—all of these things are possible.
They are welcome events to most people, and they have all actually happened in the last few months.
For example, while the S&P 500 tumbled in the first half of last year, it rose 15.7 percent from Oct. 12 to Tuesday, according to FactSet. And while the average 30-year mortgage rate rose to 7.08 percent through Nov. 8 from 3.1 percent early last year, it fell to 6.09 percent through Feb. 2, according to the Federal Reserve Bank of St. Louis Percent. Mortgage rates fell because they were linked to bond yields, which fell over the same period.
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The slump in equity and bond markets this year has been painful and it remains difficult to predict the future.
All of these things had in common that they represented an improvement in the markets and signaled optimism about the direction of inflation and interest rates. The effect was to give people more money to spend, as well as the motivation to spend it.
The exuberance in the markets was not entirely unfounded. Annual inflation, meanwhile, has fallen sharply – slowing to 6.4 percent in January from a peak of 9.1 percent in June, as measured by the consumer price index. And the federal funds rate has risen from almost zero a year ago to a range of 4.5 percent to 4.75 percent, the largest and fastest rise in 40 years. Some bond market pundits expected in late 2022 that the Fed would start cutting the federal funds rate sometime in the first half of this year, essentially declaring victory in its fight against inflation.
The problem of optimism
However, this initially somewhat abated market exuberance was tantamount to a “relaxation” or “relief” of the “financial framework conditions”. It was therefore a source of dismay for the Fed, which has been trying to tighten funding conditions for more than a year.
Minutes of the Fed FOMC meeting of Fed policymakers on March 13-14. December was revealing: “Participants noted that monetary policy is causing unwarranted easing of financial conditions because of the important function of financial markets, especially when it is due to a misperception of informing the public about the Committee’s response function would enhance the Committee’s efforts make it more difficult to restore price stability.”
The idea is that the Fed can slow down the economy by making it more expensive and harder to borrow money — and squeezing rampant inflation out of it. But this is not an easy process. It’s happening through the very channels that have shown signs of optimism – premature from the Fed’s perspective.
Two series of measurements indicate what happened. First, a Federal Reserve Bank of Chicago project using more than 100 indicators to create a National Financial Conditions Index for the overall economy shows that financial conditions tightened — as desired by the Fed — by October. But although the central bank continued to raise the federal funds rate, the index’s last reading on February 10 eased conditions.
Second, the Federal Reserve Bank of San Francisco’s Proxy Funds Rate – which uses a range of data to assess broader financial conditions on a monthly basis – shows tightening in financial conditions through November, followed by easing in January and February.
The Labor Department’s monthly jobs report was perhaps the biggest piece of good economic news in recent weeks. It suggested that the economy was picking up speed rather than slowing in the face of repeated rate hikes. Hiring figures in the United States heated up in January, adding 517,000 jobs on a seasonally adjusted basis.
uh oh
As Deutsche Bank put it in a research report, “financial conditions have not tightened enough for the Fed to have confidence” that it is winning the inflation battle. Significantly tighter tightening may be required. The bank now expects the Fed to hike short-term rates nearly a full percentage point higher.
A precarious loop
The financial markets seem to be hoping for some kind of “flawless disinflation”. The term may have been coined by Paul Krugman, the economist and columnist for the New York Times. It is used to describe hopes of taming inflation without the chaos of rising unemployment or a recession that economic theory predicts.
It is of course possible that this can happen. Supply chain shortages and erratic recoveries from the coronavirus pandemic caused some of the inflation spurt of recent years, and Russia’s war in Ukraine made matters worse. Much of this is beyond the Fed’s control.
As far as financial conditions go, the Fed and US markets could well find a sweet spot – with conditions just tight enough to slow things down but loose enough to let the good times roll in.
Fed Chairman Jerome H. Powell has repeatedly said that the central bank will not base its policy on a single outlier in economic data. But the Fed currently sees taming inflation as its core task.
“Longer higher” has become the Fed’s unofficial mantra, and unfortunately that applies not only to interest rates but also to inflation. Until inflation falls significantly more sharply, the short-term overnight interest rate controlled by the central bank will not fall either.
The Fed and markets are in a restless dance that is unlikely to go smoothly without some awkward disruptions.
That’s why I think it’s unwise to be so optimistic about the stock market until the inflation battle is over. Another major market rally should convince the Fed that it needs to hike even more and quell some market exuberance.
That could hit investors hard. But my usual advice still applies. First, make sure you have enough money with you to pay the bills. Then you should be able to withstand the coming turmoil with broadly diversified, low-cost index funds that track the entire market. Be prepared. It’s going to be a wild ride.
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