The Fed shouldn’t be baited by vigilant securities traders


Federal Reserve policymakers don’t have an explicit target for U.S. stocks or consumer borrowing costs, but they know something’s wrong when they see it, and there’s a chance it might. be one of those times. The S&P 500 index is up 17% from its June lows through Tuesday, and consumer credit is growing at one of the fastest paces ever — developments that seem counterproductive the Fed to rein in the worst inflation in 40 years.

The point is, the problem is not uniform and the Fed should avoid upsetting the whole apple basket. Instead of throwing out his roadmap on interest rates, Fed Chairman Jerome Powell will likely try to show some skill when he speaks later this month in Jackson Hole. He just needs to convince the markets that policymakers are committed to their fed funds projections and have no plans to cut rates in 2023.

The Fed, of course, is fighting inflation by raising interest rates and “tightening financial conditions,” which involves a combination of a stronger dollar, higher borrowing costs, and holdings of money. declining shares. The Fed can push the short rate as much as it wants, but its policy would not be terribly effective if the financial markets did not react in turn. The policies work in part by making it harder to finance homes and automobiles and making people with financial assets feel a bit poorer and less inclined to splurge on consumer goods. Many indices follow the general concept of “financial conditions”, including one from Bloomberg which includes factors such as money market spreads, bond market spreads, the S&P 500 and the Chicago Board Options Exchange Volatility Index. If you follow these clues, it has recently appeared that conditions have eased again.

But how does all this happen in the real economy? The Fed’s interest rate policy quickly cooled the housing market and helped send auto prices boiling. For housing in particular, it’s hard to argue that the central bank needs to push much harder than it is currently. Housing starts plummet; buyers fall back; and the pace of home price appreciation slows significantly.

Indeed, home values ​​are falling month over month in about a fifth of the 100 largest metropolitan areas, according to data from Zillow. As such, the current 5.5% 30-year mortgage rate seems appropriate for the delicate task at hand: the Fed needed to stifle the market without completely scaring off builders, as the country badly needs housing supply. to put the market on a sustainable path. If the Fed had separate housing leverage (it doesn’t), perhaps its best game would be to leave mortgage rates unchanged and see where the market settles. Admittedly, now is not the time to consider selling mortgage-backed securities off its balance sheet.

Next, consider the corporate bond market, which itself is in quite a good position. Clearly, many borrowers stocked up on new financing in 2020 and 2021 when rates bottomed out, and financing has clearly slowed, meaning the most wasteful and irresponsible projects of 2021 are no longer being financed. , but real and economically viable projects are. The corporate bond market remains open for business – there is no buyers’ strike – so liquidity constraints are unlikely to precipitate a crisis any time soon. These are good and healthy developments that are consistent with the Fed’s inflation-fighting mission.

Finally, there is the mighty dollar. It may have weakened somewhat in recent days, but on a trade-weighted basis it remains extraordinarily strong, limiting the cost of some imports around the edges (and helping inflation) and restricting exports. Is the top in? Perhaps, but the impact has already been felt in the rapidly cooling U.S. manufacturing sector, which is already suffering from supply chain bottlenecks and a weakening Chinese economy.

Yet there are other parts of the economy where the Fed doesn’t seem to be going.

Start with consumer spending. In nominal terms, it is holding up well, helped by a significant jump in consumer credit, including credit cards. A report released Wednesday showed retail sales without autos or gasoline rose 0.7% in July from June. Obviously, a few hundred basis points on their credit card APR isn’t going to stop consumers. Americans also remain eager to catch up on leisure experiences they missed during the worst of the pandemic. Carnival Cruise Line even said on Monday that bookings were almost double the level of the comparable period in 2019. Provided these trends have room, it fuels the inflationary fire.

To significantly cool consumer demand, the Fed may need to engineer a shift in sentiment, and that’s where equities come in. Equity traders have been the most overt vigilantes of financial conditions. The S&P 500’s summer rally put the S&P around 10% below its all-time high at Tuesday’s close, meaning investors are still up an impressive 38% since 2019. Even the crowd of the same stocks is living up to its old tricks, with recent target Bed Bath & Beyond Inc. more than quadrupling in value since Aug. 4. and they have a significant impact on how Americans view the outlook, and it doesn’t look like a market primed to fight inflation.

All in all, the Fed has work to do, but indices that track financial conditions can obscure some of the complex developments unfolding beneath the surface. The Fed’s transmission mechanism isn’t broken — it’s just having mixed success — and overreacting to the summer market rally could foul the parts that actually work. At times like these, President Powell’s best tool is his rhetoric, and he’s likely to use it when he takes to the microphone in Jackson Hole later this month.

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Jonathan Levin has worked as a Bloomberg reporter in Latin America and the United States, covering finance, markets, and mergers and acquisitions. Most recently, he served as the company’s Miami office manager. He holds the CFA charter.

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