Why the Fed might want to jolt the markets
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Fed chair Jerome Powell at a hearing earlier this month. Photo: Brendan Smialowski-Pool/Getty Images
So far, financial markets are cooperating nicely with the Federal Reserve's efforts to restrain inflation. They're doing the Fed's work for it by creating tighter financial conditions, in a distinctly non-panicky way.
- But as the central bank's policymakers meet this week, an underlying question they face is whether the adjustment is happening too slowly.
Why it matters: The Fed likes to move gradually to avoid spooking markets. But if its leaders conclude they are as behind the curve on re-setting monetary policy as some believe, it could mean more abrupt moves with far-reaching consequences.
By the numbers: Since the Fed's hawkish pivot began in mid-November, market moves have been consistent with the central bank's goals of achieving tighter financial conditions in an orderly way.
- Bond yields have risen substantially, but not because investors expect higher inflation. Rather, inflation-adjusted rates are rising. The real yield on 10-year Treasuries has risen 58 basis points since November 9.
- Stocks and other risky assets have fallen, but in an exceptionally orderly way. The S&P 500 is down nearly 8% from its early January high, but with no one-day drops of more than 2%. The frothiest corners of the market have sold off the most.
So far so good. The risk for the Fed now is that its gradualism is still leaving market conditions too loose to do enough to rein in inflation.
Even after a steep rise in last couple of months, for example, the spread between BBB-rated corporate bond yields and Treasuries was only 1.1% last week, compared to an average of 1.59% throughout 2019. Financial conditions are still extremely loose by any historical standard.
The implication: It might take a bit of a hawkish surprise at Fed chair Jerome Powell's Wednesday press conference to get the attention of markets, even if it makes for a volatile period on Wall Street.
It's not just the usual cranks and perma-hawks raising this possibility.
- "A measured jolt could help better align financial markets and conditions with the Fed’s rhetoric and outlook, without triggering undue volatility," Mark Sobel, US chairman of the Official Monetary and Financial Institutions Forum, wrote last week.
What would that mean? Powell could convey on Wednesday that the Fed might raise interest rates at consecutive meetings, unlike in the last tightening cycle.
- He could also indicate that the Fed is not constrained by the quarter-point-rate-hike-at-a-time norm of the last two decades, and could raise rates half a percent or more in one fell swoop.
- More dramatic steps would include announcing an immediate end to Fed bond purchases (instead of tapering those purchases through March) — or even raising rates this week, a possibility futures markets assign only 5% odds.
Yes, but: Those more aggressive measures are more likely to achieve the goal of tighter financial conditions, but also stand greater risk of breaking things in the markets and the real economy, potentially undermining the choppy recovery.
The bottom line: A little bit of market volatility now might put the economy in a more balanced place down the road — but threading that needle will be no easy task for Powell and company.
