Fed Warns, Markets Laugh Off

Valuations Surge Despite Powell's Caution

Alan Greenspan, then Chairman of the Federal Reserve, spoke in December 1996 about the “irrational exuberance” of investors in referring to equity valuations becoming stretched during the dot-com boom. Equities continued to rise for four more years before they were brought down by the 2001 recession and the aftermath of 9 / 11. The current Chairman got a similar reaction from markets following his expression of caution yesterday.

Speaking at Spelman College in Atlanta, Jerome Powell warned that “the FOMC [Federal Open Markets Committee] is strongly committed to bringing inflation down to 2 percent over time, and to keeping policy restrictive until we are confident that inflation is on a path to that objective.” To make sure that his message got through, he emphasized that “it would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease.”

Powell’s speech came at the end of a week that had witnessed Treasury yields plunge and equities soar following an improved set of statistics released on Thursday for the PCE deflator, the Fed’s favorite inflation index. The Powell comments may have been intended to curb investor enthusiasm following a talk given on Tuesday by Fed Governor Christopher Waller, until then considered to be a hawk on the FOMC. Waller said that the economy had slowed, and expressed confidence that this would bring inflation down to the Fed’s 2% target.

Despite Powell’s circumspection, equities and Treasurys had a winning day, week and month. S&P 500 index stood at its highest level last night since March 2022. The yield on 10-year Treasurys fell by 13 basis points yesterday alone, to 4.2%. By comparison, the yield had reached a cyclical high of 5.02% as recently as October 23. The yield on two-year securities that reflect market perception of future Fed action plunged by 40 bp during the week, and by 16 bp yesterday alone, to close the week at 4.55%. Recall that the two-year yield had peaked this year at 5.23% in October.

What explains the markets’ exuberance despite the Chairman’s seeming vigilance? Even though Powell explicitly stated that it is too early to time when the Federal Funds rate will start to decline, investors believe that the central bank will pause on December 13 for a third occasion in a row, and are figuring in cuts sometime in the initial months of 2024.

Several factors account for the divergence between policy guidance and market behavior. First, investors remember that Powell said at his November 1 press conference that the surge in Treasury yields in October was essentially doing the Fed’s job by tightening financial conditions. Having implicitly suggested that the Treasury market was doing a better job of mitigating inflation than the authorities, did it not stand to reason that falling bond yields are a reflection of softening price pressures? No surprise that bond and equity markets reacted positively to such an inference.

Second, time and time again, Powell has explained that there are no consistent principles that he and his colleagues follow to set interest rates or determine the pace of decline in the Fed’s balance sheet. Even yesterday, he stressed that “we are making decisions meeting by meeting,” something I equate to seat-of-the-pants decision making rather than be based on well-reasoned principles. In other words, the Chairman may well drop his sense of caution by the January 30 -31 FOMC meeting, if not at the next meeting in 10 days.

Third, if he wanted to restrain enthusiasm and be certain that equities corrected and Treasury yields rose in response to his comments, the Chairman should have provided guideposts for investors that would signal easing in monetary policy. Among these guideposts would be headline and core inflation rates attaining, and staying in the neighborhood of, specific levels; the extent to which wage increases should moderate relative to inflation; and how far unemployment may have to rise to restrain consumer demand.

Fourth, many market players who were not around to experience sharp U-turns toward higher inflation in the 1970s and 1980s believe that it is just a matter of time before the US economy returns to the post-2008 experience of sustained, low inflation rates. There is still too much fiscal and monetary stimulus left in the system to feel certain about getting back to benign inflation rates. Persistence of near-zero policy interest rates following the Global Financial Crisis boosted equity markets but reduced incomes for lower income groups dependent on interest earnings from bank deposits. Post-covid fiscal stimulus aimed at these individuals is a major reason for the different behavior of inflation.

Powell and his colleagues have a credibility problem with investors. Painful though the process may be, working to regain credibility is essential for policy to achieve its objectives.

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

December 2, 2023

Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities.  Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.

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