Federal Reserve Chairman Jerome Powell’s press conference Wednesday was eagerly awaited. He had already surprised markets on November 30 by telling the Senate Banking Committee that tapering of bond purchases will be accelerated and that purchases could end earlier than anticipated. In providing details last week, he said that the central bank would double the pace of reduction of bond buys in January and again in February, ending quantitative easing by mid-March. Federal Open Markets Committee members have penciled in three rate hikes during 2022.
Markets reacted to the details with a sigh of relief. Equities rallied and long-dated Treasury yields rose slightly during the rest of Wednesday’s session. After all, the Powell message was not as harsh as it could have been given that the most recent inflation figure for consumer prices was the highest in almost 40 years — it was also over three times the Fed target of 2%.
The euphoria faded by week’s end. Equity indexes fell Thursday and Friday. While equities have rallied to new records over the past year despite repeated covid waves, propelled by a sea of liquidity and some $4 trillion of fiscal spending, the prospect of several rate increases hit investors hard. If Uncle Jay will no longer repeat his “transitory” mantra and is going to be forced by persistently high inflation rates to increase interest rates several times, a major source that had backstopped the market would vanish. The feast of zero interest rates and $120 billion of monthly bond purchases is ending.
The shift from equities was to long-dated Treasurys. While the Fed decision initially resulted in the 2 - 10 Treasury yield curve steepening, the yield curve flattened and the yield on the 10-year Treasury fell sharply on Friday — investors started to fear that the Fed may overdo the tightening, provoking a recession.
What could be the next step? Some market watchers — myself including — have looked at a past December —2018 — for guidance. Powell, completing his first year as Chairman, had increased rates four times. On December 19, he signaled at his press conference that the Fed had more rate increases in store for 2019. Rather than provide Christmas cheer and welcome the new year, markets cratered during the final days of December.
Speaking at the American Economic Association annual meeting on January 4, 2019, Powell did a total pivot. The Fed would go easy with policy changes, he promised, rendering his statement two weeks earlier essentially inoperative. Even though no inflation, growth or employment data had prompted the shift, the central bank had changed policy. The Federal Funds rate was actually reduced three times that year.
When President Woodrow Wilson signed the new central bank law in 1913, the Act mandated that it conduct monetary policy “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Providing a backstop to equity investors whenever prices go down, thereby increasing speculative fervor, has never been part of the stated mandate.
But could Powell pivot again following his policy pivot of last week? Having allowed inflation to rise to historic highs by doubling the asset base of the Federal Reserve since the start of covid and maintaining near-zero rates even though the economy has recovered, the Federal Reserve will have to tighten massively. This is likely far more than the three rate hikes contemplated for 2022. Even before it provokes a recession, such a tough policy will likely hit the stock market. And, we know, that is what Powell fears the most.
If he shifts 180 degrees not once but twice, Powell will end up where he started, viz., an easier monetary stance. But inflationary forces are not likely to appreciate and work with political niceties.
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California
srikumar@srikumarglobal.com
@SriKGlobal
December 18, 2021
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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