Many viewed the market retreat this week, including the Nasdaq’s sharp fall, in response to the release of minutes of the US Federal Reserve’s December meeting that were more restrictive than expected. This raises two interesting questions for markets and the economy: Why were investors surprised and what are the effects on future price developments?
The market moving aspect resulted from the higher combined likelihood of three policies in 2022: the end of large-scale asset purchases; a series of rate hikes; and the possibility of the Fed starting to reduce its balance sheet.
The trigger for this was twofold: The Fed realized – albeit belatedly – that US inflation was and will remain higher and more persistent than expected and is therefore well above its target; and the assessment that if it has not already done so, the US labor market will soon meet the second element of the Fed’s dual goals, maximum employment
Given the economic data leading up to the Fed’s December meeting, let alone what has come since then, neither of these two factors should have come as much of a surprise to markets. The fact that they were is due to another incomplete correspondence between the content of the Federal Reserve Open Market Committee’s discussions and what was presented in the press conference that followed. This is particularly true of the handling of a possible shortening of the Fed’s balance sheet.
What happens next will largely depend on whether developments in inflation and employment confirm the now more restrictive expectations.
While the Fed still has a window for an orderly normalization of monetary policy, there are two reasons why this opening is uncomfortably narrower than it was or ever had to be a few months ago. (Note that the Fed repeatedly advocated starting its tapering process back in April last year.)
First, the Fed’s ongoing misinterpretation of inflation dynamics means it must now act virtually concurrently with three measures that reduce monetary accommodation, which greatly increases the risk of monetary misstep. Second, there is a risk that this withdrawal of residential real estate will coincide with other contracting winds, which assume a de facto tightening of budgetary policy and the erosion of household savings and threaten a further weakening of the economic growth momentum.
Given the extent to which the Fed’s record liquidity has driven asset prices higher in recent years, it should come as no surprise that the likely reduction in that liquidity worries the prospect for a fourth straight year of double-digit returns for US returns -Shares. Whether there are absolute losses depends largely on whether the second driver of the “everything rally” – that is, the behavior – is also reversed.
For some time now, the “Fed put” has deeply conditioned investors and traders to buy all market drops, regardless of their cause. This behavioral aspect was reinforced by FOMO (fear of missing another record high for the markets) and TINA (no alternative to risky assets given the depressed returns). All of this has contributed to slumps that have generally become shorter and less intense.
While Wednesday’s signals continued to challenge the Fed’s automatic nature, they haven’t completely changed behavioral conditioning. In fact, a significant portion of the investor base still believes that when the going gets tough, the Fed will either be unwilling or unable to confirm current monetary tightening expectations.
After all, the Fed has been forced several times in the last ten years to turn around in the direction of accommodation, including after the so-called taper rage of 2013 and in January 2019. However, for this to happen again this time, inflation would have to come down materially. Otherwise, the Fed would risk destroying its already tarnished credibility of the policy.
Since I suspect the central bank is still lagging behind local economic developments despite recent moves, it is likely that its monetary policy signals over the next few months will further undermine the markets’ notion of an automatic Fed put. The big question for business is whether the policies of a Fed that is forced to catch up will end up being bundled in such a way that financial conditions change too abruptly.
The additional question for the markets is whether the long-standing conditioning to buy the dip will prove strong enough to withstand such a remarkable change in the liquidity regime. © bloomberg
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