Many have watched the markets fall this week, including a sharp drop in the Nasdaq, as a reaction to the release of minutes from the US Federal Reserve’s December meeting that was sharper than expected. This raises two interesting issues for markets and the economy: why were investors surprised, and what are the implications of price volatility in the future?
The market-driven aspect came from the high combined likelihood of three policy moves in 2022: an end to large-scale asset purchases; a series of interest rate hikes; And chances are the Fed will start shrinking its balance sheet.
The catalyst for this was twofold: recognition by the Fed, though a late one, that US inflation would remain higher and more persistent than expected and, therefore, well above its target; And the decision that the US labor market will soon meet, if it hasn’t already, the second element of the Fed’s dual objectives, of maximizing employment.
Given the economic data for the December Fed meeting, let alone what has come since, neither of these two contributing factors should have come as a big surprise to the market. The fact is that they can be attributed to a more-than-perfect alignment between the content of the Federal Open Market Committee’s discussions and how they were quickly portrayed at the press conference. This is particularly the case with its treatment of a potential contraction of the Fed’s balance sheet.
What happens next will largely depend on whether inflation and job growth validate the now more bullish expectations.
While the Fed still has a window to deliver a systematic policy normalization, there are two reasons why this opening is uncomfortably tougher than it ever was a few months ago or so. (Consider my repeated advocacy, in early April last year, for the Fed to begin its tapering process.)
First, the Fed’s prolonged misjudgment about inflation dynamics means it now has to move virtually simultaneously with three measures that reduce monetary accommodation, increasing the risk of a policy misstep. Second, the return of housing risks, coupled with other contractionary winds resulting from real financial tightness and erosion of household savings, is threatening a major slowdown in the pace of economic growth.
Given the extent to which the US Fed’s record injections of liquidity over the past few years have propelled asset prices, it should come as no surprise that a potential shortfall of that liquidity raises concerns about double-digit prospects for the fourth year in a row. Still working. Returns for US stocks. Whether this will result in an outright loss depends largely on whether the other driver of ‘Rally Everything’ – the pragmatic – will also be reversed.
For quite some time, the ‘Fed Put’ has given investors and traders a deep bet to buy any and all market downturns, regardless of their reason. This is a behavioral aspect that has been reinforced by FOMO (fear of missing out on another set of record highs for markets) and TINA (risky assets have no choice, given how repressed yields are). . All of these have contributed to dips that have generally become shorter in duration and less intense in magnitude.
While Wednesday’s signals from the Fed raise questions about the automatic nature of Fed puts, they have not completely replaced behavioral conditioning. In fact, there is still a significant segment of the investor base that continues to believe that, when the push hits, the Fed will either prove unwilling or unable to validate current expectations about monetary tightening. .
After all, the Fed has been forced to make a U-turn toward housing several times over the past decade, including the so-called taper tantrum of 2013 and the most famous since January 2019. Yet, for this to happen again, this time around, inflation would need to come down physically. Without it, the Fed would risk destroying its already eroded policy credibility.
As I suspect that, despite recent moves, the central bank is still lagging behind economic growth on the ground, it is likely that its policy cues over the next few months will further weaken the market’s perception of automatic Fed puts. The bigger question for the economy is whether policy actions forced by the Fed to play catch-up will be so tied together as to cause a sudden change in financial conditions.
The additional question for the markets is whether the long-standing conditioning liquidity to buy the dip will prove strong enough to withstand such a remarkable change in the regime. © Bloomberg
Mohammed A. El-Erian is a Bloomberg Opinion columnist
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