01/29/2023
Fed's assessment of financial conditions could set tone
Let's get ready to rumble.
The Federal Reserve and investors appear to be locked in what one veteran market watcher has described as an epic game of "chicken." What Fed Chair Jerome Powell says Wednesday could determine the winner.
Here's the conflict. Fed policy makers have steadily insisted that the fed-funds rate, now at 4.25% to 4.5%, must rise above 5% and, importantly, stay there as the central bank attempts to bring inflation back to its 2% target. Fed-funds futures, however, show money-market traders aren't fully convinced the rate will top 5%. Perhaps more galling to Fed officials, traders expect the central bank to deliver cuts by year-end.
Stock-market investors have also bought into the latter policy "pivot" scenario, fueling a January surge for beaten down technology and growth stocks, which are particularly interest rate-sensitive. Treasury bonds have rallied, pulling down yields across the curve. And the U.S. dollar has weakened.
Cruisin' for a bruisin'?
To some market watchers, investors now appear way too big for their breeches. They expect Powell to attempt to take them down a peg or two.
How so? Look for Powell to be "unambiguously hawkish," when he holds a news conference following the conclusion of the Fed's two-day policy meeting on Wednesday, said Jose Torres , senior economist at Interactive Brokers, in a phone interview.
"Hawkish" is market lingo used to describe a central banker sounding tough on inflation and less worried about economic growth.
In Powell's case, that would likely mean emphasizing that the labor market remains significantly out of balance, calling for a significant reduction in job openings that will require monetary policy to remain restrictive for a long period, Torres said.
If Powell sounds sufficiently hawkish, "financial conditions will tighten up quickly," Torres said, in a phone interview. Treasury yields "would rise, tech would drop and the dollar would rise after a message like that." If not, then expect the tech and Treasury rally to continue and the dollar to get softer.
Hanging loose
Indeed, it's a loosening of financial conditions that's seen trying Powell's patience. Looser conditions are represented by a tightening of credit spreads, lower borrowing costs, and higher stock prices that contribute to speculative activity and increased risk taking, which helps fuel inflation. It also helps weaken the dollar, contributes to inflation through higher import costs, Torres said, noting that indexes measuring financial conditions have fallen for 14 straight weeks.
Powell and the Fed have certainly expressed concerns about the potential for loose financial conditions to undercut their inflation-fighting efforts.
The minutes of the Fed's December meeting. released in early January, contained this attention-grabbing line: " Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the Committee's reaction function, would complicate the Committee's effort to restore price stability."
