Federal Reserve Jerome Powell after testifying at a Senate confirmation hearing on Jan. 11.
Watch what they say, not what they do, at the Federal Open Market Committee meeting this coming week. The obverse of the famous advice from Richard Nixon’s attorney general, John Mitchell, is what economists and market participants will be doing on Wednesday, when the panel may elucidate its policy plans but is unlikely to take any immediate action.
To be sure, stock and bond markets have started 2022 by adjusting to the reality of a less accommodative Federal Reserve monetary policy ahead. The benchmark 10-year Treasury note’s yield is up 34 basis points since the turn of the year, at 1.836% on Thursday, while the Nasdaq Composite has entered a so-called 10% correction from its peak last November. And the federal-funds futures market has fully priced in an initial 25-basis-point increase in the Fed’s key policy rate, from the current ground-hugging 0% to 0.25%, at the March 15-16 FOMC gathering, according to the CME FedWatch site. (A basis point is 1/100th of a percentage point.)
But no rate increase is likely this week, despite a growing consensus (including from President Joe Biden) on the need for a less accommodative Fed policy, given the sharp rise of inflation. At his news conference on Wednesday, Biden expressed support for Fed Chairman Jerome Powell’s plan to “recalibrate” policy. “The critical job of making sure that the elevated prices don’t become entrenched rests with the Federal Reserve, which has a dual mandate: full employment and stable prices,” the president said.
That’s a sharp reversal of the pressure often exerted by past presidents for easier money. From Lyndon B. Johnson to Nixon and Donald Trump, presidents have variously tried to cajole or coerce Fed chairmen into lower interest rates or avoid raising them, while George H.W. Bush blamed a too-tight Fed for his electoral defeat. But now, inflation’s surge to 7% tops the list of concerns in consumer surveys, coinciding with the slide in Biden’s poll ratings, so his endorsement of a less accommodative Fed policy appears to be a matter of political necessity.
So acute have inflation concerns become that some observers are urging more immediate and dramatic actions. That includes calls for a 50-basis-point jump in the fed-funds rate, as I wrote this past week on Barrons.com, or a complete halt in the Fed’s securities purchases, as I noted here a week ago, rather than the present path of winding down its buying by March.
But both would be out of character for the Powell Fed. “I can’t imagine another big pivot,” says John Ryding, chief economic advisor at Brean Capital. For most of 2021, the monetary authorities clung to the notion of “transitory” inflation. A sharp, initial 50-basis-point hike would be an admission of how they misjudged the building price pressures, he says.
Neither does Ryding look for the Fed to emulate the Bank of Canada, which abruptly ended its securities purchases last year. “What I hope to get is clarity” from the FOMC meeting in the coming week, he added in a telephone interview.
One possible surprise would be for the FOMC to further accelerate the tapering of the purchases, winding them up by mid-February, a month earlier than currently scheduled, write Nomura economists Aichi Amemiya, Robert Dent, and Kenny Lee in a client note. That would represent a marginal reduction of $20 billion in Treasury and $10 billion in agency mortgage-backed securities acquisitions, but would send a signal to the market about the Fed’s anti-inflation resolve.
In particular, they add, a quicker windup in the Fed’s bond buying might help avoid some awkward questions for Powell at his postmeeting news conference on Wednesday afternoon. The central bank continues to buy $40 billion of Treasuries and $20 billion a month in MBS, adding to its near-$9-trillion balance sheet, which means that it is actually easing, rather than tightening, policy, while talking of the need to curb inflation.
As for the Fed beginning to normalize its balance sheet, the Nomura economists think the announcement could come as early as the March or May FOMC meeting. Most Fed watchers expect a later start to the process of reducing the central bank’s securities holdings, after two or more rate hikes. And almost all think the Fed will allow maturing issues to run off at a predictable pace, rather than sell securities outright.
Some also suggest that the Fed could reduce its holdings of mortgage-backed securities more rapidly. The Fed has expressed a preference to returning to holding only Treasuries on its balance sheet, as was the case before the 2007-09 financial crisis, Ryding notes. And for months, many critics have argued that effectively subsidizing an already overheated housing market by buying MBS makes no sense.
But the relative economic and financial impact of changes in these two main monetary policy tools—interest rates and the central bank’s asset holdings—is unknown, he says. The Fed traditionally has utilized the fed-funds rate as its main policy lever and resorted to a huge expansion in its balance sheet when its key policy rate fell to the zero lower bound. Unlike other central banks, notably the European Central Bank and the Bank of Japan , the Fed has avoided resorting to negative interest rates.
Economists Cynthia Wu of Notre Dame and Fan Dora Xia of the Bank for International Settlements have estimated that the equivalent impact of the Fed’s asset purchases in what they dub a “shadow fed-funds rate,” which is tracked by the Atlanta Fed. The Wu-Xia shadow funds rate was minus 1.15% as of Dec. 31, according to the Atlanta Fed.
Ryding says Wu estimates that a change in the Fed’s balance sheet equal to 10% of U.S. gross domestic product—about $2 trillion—is roughly equivalent to a 100 basis point change in the fed-funds rate.
How central bank bond-buying affects the economy is still debated among economists. Most see asset purchases working through what they call the portfolio channel. As former Fed Chairman Ben Bernanke explained in a Washington Post op-ed article in November 2010, the central bank buys securities to ease financial conditions, including to raise stock prices, which in turn boosts consumers’ wealth and confidence, and spurs spending.
And as the intriguing accompanying charts from Deutsche Bank ’s head of thematic research Jim Reid illustrate, the big global tech growth stocks have moved in lockstep with the assets of the major central banks. The FANG+ group used in the chart consists of Meta Platforms (the former Facebook, ticker: FB), Amazon.com (AMZN), Apple (AAPL), and Google parent Alphabet (GOOGL), plus Alibaba Group Holding (BABA), Baidu (BIDU), Nvidia (NVDA), Tesla (TSLA), and Twitter (TWTR). The big five central banks are the Fed, the ECB, the People’s Bank of China, the BoJ, and the Bank of England.
“Correlation does not imply causation, but unless you are an incredibly strong advocate of a completely new earnings paradigm for the largest technology companies that coincidently have tracked unconventional monetary policy, then it is hard to argue against the notion that central bank policies have been a big contributor to an incredible run for the sector over the last six-to-seven years. Indeed, the only notable setback has been when global [quantitative tightening] arrived in 2018,” Reid observes in a client note.
The 13% decline in the FANG+ index from its November peak through Thursday is a bit steeper than the 11.5% drop in the popular Invesco QQQ exchange-traded fund (QQQ) that tracks the biggest Nasdaq nonfinancial stocks. And that’s before the Fed actually has begun to shrink its balance sheet.
The Fed has maintained its crisis policy of zero interest rates and active bond buying, initiated in March 2020 during the near-meltdown of markets resulting from the Covid-19 pandemic. The virus and its variants persist, but the economy has largely recovered, with the unemployment rate under 4% and the labor market beset by worker shortages. Inflation, meanwhile, has soared to 7% from a combination of supply constraints and pumped-up demand.
And nowhere is the impact of Fed policy more apparent than in asset prices, from the doubling of the S&P 500 since its March 2020 bottom, to home prices jumping about 20%. Investors will be listening carefully to what Powell & Co. say this coming week and beyond about normalizing those policies.
Write to Randall W. Forsyth at firstname.lastname@example.org
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