Federal Reserve Chair Jerome Powell believes that monetary policy is carried out through financial conditions, and for the time being, he seems to like where they stand. As he told lawmakers Wednesday, “the market has been reading our reaction function reasonably well.”
That markets and the Fed are on the same page is good news for near-term volatility, but Powell’s words also contain a veiled threat: If financial assets recover too far from the recent selloff, he has ways of putting them back in their place. Investors adjust Powell’s dial at their own peril.
Bond yields have dropped sharply in the past week, and swaps are now implying a lower terminal rate than the median projection of Federal Reserve Board members and Federal Reserve Bank presidents. Meanwhile, the S&P 500 Index rose for the third consecutive day on Wednesday before giving up its gains at the close.
Some of that is probably tolerable to the Fed after last week’s vicious selloff, and snapback rallies are a healthy hallmark of all bear markets. But if markets recover too far, expect Powell and his colleagues to reassert themselves with another round of hawkish rhetoric. Fighting inflation remains their top priority, and they won’t take kindly to traders undermining that goal.
As Powell said last week, tighter monetary policy is effective when it translates into some combination of higher real-world borrowing costs, lower asset prices and a stronger dollar.
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When the Fed signals it will raise its policy rate, mortgages and loans for durable goods such as cars get more expensive (making people less inclined to borrow); investment accounts shrink (making people less inclined to spend) and the dollar appreciates (reducing the cost of imported goods).
These variables anticipate moves in the fed funds rate, which is why members of the Federal Open Market Committee have insinuated that they aren’t as far behind the curve in fighting the worst inflation in 40 years as meets the eye. Policymakers would still need to ratify the market’s expectations, but financial conditions are already at work.
While there are formulas for making monetary policy — such as the so-called Taylor rules created by economist John Taylor — it is hard to say for certain which level of stock market prices or which mortgage rate is consistent with fighting 2022’s unique inflation dynamics, including a significant supply-side component driven by Covid-19 lockdowns and the war in Ukraine. Meanwhile, policymakers constantly run the risk of pushing markets too far and causing a recession.
Powell seems committed to finding out empirically how much is enough, so a summer pause to the market’s selloff may be a welcome development. “We’re not going to be completely model-driven about this,” Powell told reporters on June 15. “We’re going to be looking at this, keeping our eyes open” to developments in the economy and financial markets. Of course, if they don’t like what they see, they won’t hesitate to take action. — Bloomberg Opinion
