Is the Fed Put Still On?
The much awaited first Federal Reserve’s meeting in 2022 finally occurred yesterday. Markets were in turmoil in the days leading to the FOMC decisions as recent commentaries from Fed’ officials indicated a slight change in their attitude and tolerance toward inflationary pressure.
Ultimately, Jay Powell did not do anything unexpected. He did not raise rates preventively nor did he commit to more or larger future rate increases than the market is currently factoring in.
Chairman Powell did confirm, however, that this Quantitative Easing program will end in March and that rates will start increasing in the same month. He also sounded much more concerned about inflationary pressure and the strength of the labor market that he has ever been. It seems that Fed’s psychology has shifted from a focus on short term supply issues as the main culprit for inflation to shortages in the labor market. A focus on employment forces the Fed to be more active in reducing aggregate demand but it also opens the door to policy mistakes. If the post-Omicron economic boom fades quickly, the long lag of restrictive monetary policy might slow demand right at the time when the economy may be already organically decelerating.
The bond market seems to still be on Powell’s side. The yield curve, as in the difference between the 10-year Treasuries and the 2-year Treasury notes, actually flattened reflecting the belief that higher short-term rates will cause a gentle slowdown and be successful in cooling off inflation. An inverted curve, should we see that in the future, will signal a renewed pessimistic view from bond traders.
On the other hand, the equity market showed a schizophrenic reaction. First, it moved up in relief that the Fed did not do anything more hawkish than expected but then fell amid concerns that the notorious Fed put might have a strike much lower than usual.
The Fed put symbolizes the propensity of the Federal Reserve to act quickly in injecting liquidity in capital markets when volatility rises. Historically, the Fed has been very sensitive to quick moves in volatility metrics, but the new inflation paradigm is spooking traders who are beginning to think Powell will be slower to react than in the past. The fact that Powell was also very vague on how to shrink the Fed’s balance sheet created confusion among traders and investors. One significant reason for financial assets strong returns in the past few years has been the Quantitative Easing program; reversing that dynamic will surely create a headwind for asset prices. The lack of details on how to implement this reversal of strategy is understandable as we are in uncharted territories, but it certainly unnerves market participants.
In conclusion, it is hard to believe that the Fed will become significantly restrictive. The large and increasingly larger size of public debt prevents any kind of serious tightening in rates. In fact, real rates, or the difference between nominal rates and inflation, have only been positive for a few months over the last 14 years! Some kind of real rate normalization would probably be a long-term positive.
In conclusion, the convergence of all these economic elements and subsequent monetary responses seem to stress our year end prediction that 2022 will be marked by much higher volatility and low returns.