The Fed's Negative Message for the Markets

The stock market remains at risk for further declines.  Last week's market's plunge was likely exacerbated by a disconnect between Fed Chair Powell's hawkish anti-inflation message and the more measured forecasts contained in the FOMC Central Tendencies.  Powell was firm in leaving open the possibility that the Central Tendencies understate the extent of Fed tightening ahead.  To be sure, an understatement probably becomes relevant as a risk for the December FOMC Meeting on.  This is because a 75 BP hike at the November FOMC Meeting, consistent with the Central Tendencies, is probably a given.  Whether the market gets some relief in October, ahead of the November Meeting, could depend on the September Employment and CPI Reports surprising on the weak side.

Fed Chair Powell's said the Fed will not stop tightening until there is significant evidence that inflation is moving down to the 2% target.  Although he thinks the moderate pace of further tightening contained in the Fed's Central Tendencies is a reasonable expectation, it does not stand in the way for the Fed to tighten more aggressively if needed.  Policy will "evolve" as data come in.  In other words, take the Central Tendencies for what they're worth -- just forecasts -- and don't rule out additional tightening to what is built into them.  The Fed is adamant to make sure inflation will no longer be a problem.

He says financial markets are an important channel through which monetary policy will work to slow the economy and thus lower inflation.  Stocks have to fall, yields rise and dollar strengthen.  With Powell's stern warning in mind, financial markets may overshoot -- moving more than what will be necessary to achieve the Fed's goal.  Markets don't know how much tightening of financial conditions is needed to lower inflation -- and evidence becomes available with a lag.  The restrictive market moves may not end until significant evidence of a weaker labor market and lower inflation shows up.  This evidence would put a lid on Fed tightening. 

The Fed's Central Tendency forecasts are not as dire for the markets as Powell's warnings.  Most FOMC participants expect the Fed funds rate to end the year in the 4.0-4.5% area, suggesting some downshifting over the next two FOMC Meetngs after the funds rate was hiked to 3.25% last week -- most likely in December as another 75 BP hike in November makes sense for reasons I discussed last week.  The rate is seen being hiked just another 50 BPs in 2023, peaking at 4.6%.  Last week's Treasury market sell-off brought yields closer in line with the Central Tendency forecasts.  So, the worst may be over for now, but a relaxation of the sell-off may not last for long.

To put the 4.6% funds rate end-point in perspective, it is on the low side compared to past peaks (5.3-19.9%) that were followed by recession.  But, there are several reasons why it may be as powerful as rate hikes prior to past recessions.  /1/ The 4-1/2 percentage point increase from the trough in March is on the high side of the range of rate increases seen prior to recent recessions and /2/ has happened faster than in the past.  For example, it rose about 4 percentage points to 5.3% prior to the Great Recession of 2008, but it happened over 2-1/2 years.  Generally, it is not clear whether the level of the funds rate or extent/speed of increase in the funds rate is more important regarding economic growth.  /3/ The increase in the funds rate is being accompanied by reductions in the Fed's balance sheet, which could exacerbate the tightening at the long end of the Treasury yield curve.  

The other Central Tendency forecasts are fairly benign from a market perspective.  The FOMC expects below-trend economic growth in 2022 and 2023 -- not recession.  The Unemployment Rate is expected to climb modestly, peaking at 4.5%, and inflation to slow sharply over the next two years.

Specifically, Powell said the Fed wants to see /1/ higher Unemployment, /2/ a drop in Job Openings and Quits, /3/ a slowdown in wage inflation, and /4/ a slowdown in price inflation.  Unemployment Insurance Claims are the highest frequency data to watch regarding the labor market.  The latest data run counter to what the Fed wants to see.  Both Initial and Continuing Claims remain in a downtrend that began in mid-August.  Unless they begin to move up sharply, they will argue for more rate hikes.