Fed to Markets: “Drop Dead”

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Dec 20, 2018 12:42:47 PM

and tagged Commentary

Leave a comment

FedOf course, here I am riffing on the famous headline published after President Ford refused to bail out New York City (see below). Yesterday, there is no doubt that markets were expecting a bailout from the Fed—and threw a tantrum when they didn’t get it.

Fed stepping back

The expected bailout the markets were looking for was that the Fed would raise rates at this meeting (which it did) but also that the Fed would signal that future rate increases were less likely (a “dovish” hike, in the jargon). The hike would signal current economic strength, while backing off future increases would indicate that the Fed was aware and concerned about recent market pullbacks—and would act to stop them.

Instead? Powell and the board came right out and said that, yes, expectations have weakened a bit. They also indicated that they will probably hike rates only twice next year—but will keep raising rates. By pretty much ignoring the recent financial market turmoil and focusing on continued economic strength, Powell put the markets on notice that the Fed will be much less willing to shape monetary policy in order to support asset prices. With the Fed stepping back, markets will be on their own in a way they have not been for decades.

Safety net for financial markets

The Fed’s actual mandate, by law, is to support price stability and maximum employment. It also, by default, has assumed responsibility for financial stability. All of these obligations are consistent with what a central bank should and has to do. In recent decades, however, starting with Chair Greenspan, the Fed was also widely perceived to offer a safety net for financial markets. The “Greenspan put,” as it was called, meant that the Fed would step in and ease monetary policy by lowering rates whenever the stock market took too big a dive.

While this was never official policy, this is exactly what Greenspan (and then Bernanke and then Yellen) were seen to do. Markets naturally began to expect and even depend on the Fed to step in when markets tanked, and that is just what they anticipated yesterday. If Powell had announced the Fed was pausing the rate increases until markets stabilized, that would have been very positive. Indeed, that’s what markets wanted and more than half expected.

No Powell put, no surprise

He didn’t do that, though. In this decision, he was supported by the board as a whole. Instead, he ignored the recent turbulence and focused on what the Fed, by law, is supposed to do. By doing so, he very publicly demonstrated that there won’t be a Powell put any time soon.

Powell is on record as advocating just this approach, and this has been well known. Moreover, economists have been calling on the Fed to step away from the Fed put for years. Given that, and the need to keep raising rates to prepare for the next recession, the actual result should not have been a surprise. It clearly was, however, and I think we can expect more turbulence as markets adjust to the idea that the Fed safety net, if it still exists at all, is considerably more threadbare than what they have been used to.

A more rational system

Ultimately, this shift will be a good thing, as it will make investors more cautious, the system safer, and the capital allocation process—which is what markets are ultimately for—more rational and thus better for the economy. Arguably, the asset price bubbles that have driven the crises of the past couple of decades have been enabled by the Fed put. A more rational system, with asset prices left to markets, should be less prone to bubbles. The road from here to there is likely to be rocky, however.

At this point, only one thing is really clear. There’s a new sheriff in town.

Fed
Source: New York Daily News

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®