Did the Stock Market Overreact?

The stock market will likely continue to be weighed down by fears of aggressive Fed tightening as the May 3-4 FOMC meeting approaches.  But, some snapback from last week's plunge is conceivable.

Fed Chair Powell's comments last week underscored that fighting inflation is now the Fed's primary target and that front-loaded aggressive moves would be appropriate in this fight.  However, the markets may have exaggerated the implication of his comments, particularly after St Louis Fed President Bullard (a hawk) had suggested the possibility of a 75 BP hike.  Cleveland Fed President Mester was more even-handed, saying only 50 BP hikes (aiming for a 2.5% Fed funds target by year end) would be needed as she did not want the Fed to disrupt the economic expansion.  Her view is probably representative of the Fed leadership -- although Powell's comments were focused mainly on fighting inflation.  Her comments could spark a stock market snapback early this week.

To be sure, front-loading Fed tightening is the standard result of an "optimal control" solution to the Fed's econometric model of the US economy if the goal is to bring down inflation while keeping unemployment low over time -- which I showed in my PhD dissertation (see below).  The idea is that pushing up the unemployment rate quickly will not only depress wage inflation and thus price inflation but also inflation expectations.  The latter, along with greater labor market slack, will help hold down wage inflation in the future and thereby allow for a renewed decline in the unemployment rate in a non-inflationary way.  Ironically, Janet Yellen, when she was Fed Chair, used optimal control results to argue for continuing low interest rates.  The optimal control solutions depend not only on the Fed's goals regarding unemployment and inflation, but also on the conditions facing the economy.

A front-loaded, aggressive tightening in monetary policy risks going too far and pushing the economy into recession.  But, this is not necessary.  In the past, a major difference between Fed tightenings that resulted in recession and those that did not is how quickly the Fed reacted to signs of economic weakness.  When the Fed continued to tighten in the face of weaker data, the economy fell into recession.  When it stopped tightening or even eased, a short-lived slowdown occurred.  These growth pauses generated labor market slack that permitted growth to pick up without igniting inflation.  So, from a stock market perspective, the end of "Fed Fear" will be when Fedspeak shifts to recognizing a significant slowing in economic activity -- suggesting a downshift if not an end of tightening is in sight.

Upcoming key US economic data are not likely to show a significant, if any, slowing, however.  The Unemployment Claims data remain low -- suggesting a solid gain in April Payrolls --  and a number of manufacturing surveys picked up in April -- suggesting an increase in the Mfg ISM.    

This week's US economic data will feature the first print of Q122 Real GDP Growth, the Q122 Employment Cost Index and the March PCE Deflator.  Consensus looks for a sharp slowdown in Q122 Real GDP to 1.0% from the out-sized 6.9% in Q422.  The Atlanta Fed model's estimate is 1.3%.  Much of the slowdown may reflect a drop in inventory investment, which the market will likely view as a signal for stronger growth in Q222.  Consensus expects +1.1% q/q for the Q122 Employment Cost Index, versus +1.0% in Q421.  Not all evidence points to a speedup, but the print should exceed the pre-pandemic pace of about 0.7%.  Consensus looks for +0.3% m/m March Core PCE Deflator -- same as the CPI.  There may be upside risk, however, since the drop in Used Car Prices that held down the CPI is much less important in the PCE Deflator.

P.S.  An optimal control solution shows how monetary policy should move to result in the lowest unemployment rate and inflation during a period of time, where monetary policy, unemployment and inflation are tied together in a model of the economy.  Technically, it is a maximization problem subject to constraints, where the function being maximized includes the unemployment and inflation rates and the model the constraints.  A solution shows the path of the Fed funds rate that, according to the econometric model (the constraints), will result in the lowest combination of unemployment and inflation during the period of time, say two years.