Learning to Believe the Fed

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Federal Reserve Chairman Jerome Powell



Photo:

Tom Williams/Associated Press

Does Wall Street finally believe the Federal Reserve? Officials have warned for weeks that the central bank would tighten policy faster than many expected to break inflation. So the tumult among bond and stock traders after Chairman

Jerome Powell

repeated the promise on Thursday is late in coming.

Mr. Powell all but confirmed the Fed will raise its policy rate by 50 basis points in May, more than the usual 25-point move. Stocks and bonds promptly tumbled, with the S&P 500 down 1.5% Thursday and another 2.8% Friday, the Nasdaq falling 2.1% and then 2.6%, and the 10-year Treasury yield spiking to 2.917% Thursday.

The market moves—as Fed tightening has hardly begun—underscore the credibility challenge the central bank has created for itself. Investors were surprised Thursday because they’ve been conditioned to believe the Fed will always come through with a put to buttress the market.

And who can blame traders? Going back to the

Alan Greenspan

era, the Fed has acted as if rising asset prices are a measure of its success. Mr. Powell delayed winding down pandemic-era asset purchases under its quantitative-easing program so he’d have time to warn investors that change was coming. A bad market reaction to quantitative tightening, the 2013 taper tantrum, lives in Fed lore, and markets know the Fed wants to avoid another one.

With the Fed now accelerating the runoff of its QE portfolio, bond markets are rediscovering how to trade without the central bank sitting on the long end. Investors may be concluding that controlling inflation will take higher rates and perhaps some economic pain, if not a recession. Some might call this a rout, but we’d call it a market “signal.”

Equities also may be in for rude surprises. Investors who bid up stock prices for two years must now grapple with the effect of rising rates on valuations, and the danger that slower economic growth poses to earnings. Oh, and the threat of higher taxes and more onerous regulations from Washington at least until November’s election.

The Fed will have to ignore all this as it battles inflation, especially if it hopes to shore up its credibility. But standing firm may be Mr. Powell’s greatest challenge. Market ructions are likely to continue, and the revaluation of assets may lead to a financial failure or three. Bank balance sheets are sturdier than in 2006 and consumers are in better financial shape, but we won’t know until the end whether they’re solvent enough. Housing will be a question mark as recent price rises moderate.

The international context has also rarely been more complex. Europe is on the brink of recession. China’s zero-Covid lockdowns are gnarling supply chains. A rapidly depreciating Japanese yen (now below ¥128 to the dollar) is triggering panic in Tokyo over the health of the world’s third-largest economy.

Investors are due several queasy turns on the roller coaster as they ride out this economic change. Our advice to Mr. Powell: Let markets find their new equilibrium on their own. The Fed’s most important job is price stability. The Fed is in this fix because it waited too long to rein in inflation and let markets think they had too much influence on his thinking.

As for investors, perhaps it’s time to call your favorite retired bond trader who recalls the challenges of the 1970s and early ’80s. The Fed led everyone to believe those days were past. Retro is back on Wall Street.

Journal Editorial Report: Paul Gigot interviews former Trump economics chief Kevin Hassett. Images: Getty Images Composite: Mark Kelly

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Appeared in the April 23, 2022, print edition.

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