New Fed Tools Promise Volatile Markets

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Ever since the Taper Tantrum in the spring of 2013, the Federal Reserve has placed a premium on guiding market expectations and then keeping its word. This summer, fighting inflation is the most important policy goal – perhaps the only one for 2022-2023. Inside the central bank, officials believe it made a major inflation error last year by sticking with its earlier statements rate hikes would follow the conclusion to this cycle’s balance sheet taper.

Dealers and investors were jolted by the Fed’s 75bp increase at the June FOMC, previewed just two days earlier in the press, after relying on weeks of Fed statements indicating 50bp was the preferred increase for the next several meetings. It wasn’t the size of the change that damaged markets, it was the change itself. It produced the most volatile week for interest rates this year, comparable to the first week of March when Russia shelled the nuclear power plant in Chernobyl.

Treasuries offer the most liquid fixed income markets in the world, but the Fed’s shockwave overwhelmed the system. This index measures Treasury inefficiency – market levels versus a smoothed curve – as a symptom of poor liquidity.

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It’s of no comfort that central bank policy in Europe has slammed liquidity there even worse than here. Rather, the Fed’s abrupt change confirmed it welcomes market instability in stocks and bonds because it tightens financial conditions. Lifting a quote from Chair Powell’s answer to a difficult question at the June press conference:

…we move the policy rate, that affects financial conditions, and that affects the economy. We have of course, ways, rigorous ways to think about it, but ultimately it comes down to do we think financial conditions are in a place where they're having the desired effect on the economy?

Financial conditions have deteriorated to the worst in the last three years outside the spike in March 2020 that the Fed combatted with waves of quantitative easing. The last time financial conditions were this bad due to the economic cycle or monetary policy, the Fed backed away from its guidance to send rates another 100bp higher in 2019. Of course, core inflation at that point was 2.0%, and the FOMC did not want it to decline again.

Both in Fed theory and in actual practice, an inflationary cycle depends on certainty, or at least elevated confidence. One reason oil prices rise is because OPEC refuses to increase production. It relies on its economists’ forecasts that rising prices will not slow demand, so higher prices on limited production optimizes revenues. Until, that is, the confidence that buyers can absorb or pass along higher costs begins to unwind.

Falling stocks, erratic bond prices, wider spreads when investment grade credit is stronger, gyrating crypto currencies, and industrial commodities all widen cracks in the wall of inflation and confidence prices will climb further. The Fed predicts, though, the instability by itself will not trigger a recession.

The Fed mostly relied on the impact of rising rates to slow the economy in previous cycles. It has increased the importance of financial conditions because borrowers no longer rely on short-term debt as they once did. As just one example, money market instruments – most sensitive to fed funds – now comprise 5% of total liabilities in the banking system, not the 20+% prior to the financial crisis and half the percentage it was in the last tightening.

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Data dependent? Not so much any more

The pet phrase of every central banker when talking about future decisions is “data dependent.” When it comes to describing the US economy, however, the Fed expresses enthusiasm based on 2022’s strong labor market data. As economists have wondered since late 2021, however, how strong can the labor market actually be if wages and salaries persistently lag inflation? Real income has been falling since August 2021.

On inflation, what’s the most important index and where the does the Fed source inflation expectations? For decades, the most important index was the core PCE. But, Chair Powell tied the decision to accelerate rate hikes tied to surprises in the headline CPI on the Friday before the June FOMC. Market inflation expectations fell before the June meeting, without a mention at the press conference, and fell even faster afterward.

The Fed has not suddenly lost its economic compass, however. It is choosing to emphasize its inflation message with as many supportive data points as possible, neglecting those that could be interpreted as drawing it off course. That choice is all well and good, but by stressing data dependency the Fed contributes to financial market disruptions. Traders will react to data releases the Fed says it is following, when actually Fed economists are exploring other corners of the economy.

Worse, investors may chase red herrings in search of the next Fed surprise. If the headline CPI surprises to the upside again in coming months, does that require still faster rate hikes, perhaps 100bp? When asked that very question directly at his last press conference, Powell ducked it completely. The market can never duck a Fed threat, though, and may react despite the uncertainty.

Summary

Forward guidance on interest rates was incredibly effective when rock bottom rates kept the economy afloat. Setting a minimum time for rates at 25bp or lower was the Fed’s preferred approach versus the negative interest rates applied in Europe and elsewhere. Its credibility depends, naturally, on the Fed following through on its statements.System (RTRS).

A polite central bank might offer a mumbled apology for backtracking on forward guidance with just two-day notice, but a mean, tough, inflation-fighting central bank offers no apologies to anyone. When you throw away forward guidance, it communicates the gloves are off, and it’s bare-knuckled street brawling. Bond dealers are on notice.

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