Written exclusively for InTouch Capital Markets
9th February 2018
By Steven K. Beckner
As stocks continued a roller coaster ride that brought them into “correction” territory by week’s end, Federal Reserve officials walked a fine line between reassuring financial markets while steering a monetary course befitting a strengthening expansion.
The Fed has a well-earned reputation for setting interest rates to support stock prices. Indeed, it was conscious Fed policy to encourage investments in riskier assets by holding rates low that helped cause the record-breaking run-up in stock prices. We’re now seeing the bursting of that bubble as a consequence of rate “normalization”
But whereas in other times, the Fed’s rate-setting Federal Open Market Committee might have pulled its punches in response to a sell-off, officials have given few signs they are prepared to do so this time — because stocks are correcting for the same reason the Fed is planning on “further” rate hikes: a quickening growth pace, tightening labor markets, faster wage growth and signs inflation at last seems headed for 2%.
It’s just that markets, whose rate expectations were once lower than the Fed’s, have gone overboard in their rate fears. So officials have been trying to modulate those worries — with mixed success.
Wednesday, when the market had recovered somewhat from the cumulative 7.1% drop in the Dow of Friday and Monday but was still extremely volatile, a soothing San Francisco Federal Reserve Bank President John Williams said “the outlook is positive: The expansion is proceeding at a good pace, unemployment is low, and inflation is finally headed in the right direction again….”
“But while the outlook is positive, it’s not so strong that it’s driving a sea change in my position,” he continued. “For the moment, I don’t see signs of an economy going into overdrive or a bubble about to burst, so I have not adjusted my views of appropriate monetary policy. So my message to those concerned about a knee-jerk reaction from the Fed is that, as always, we’ll keep our focus on the dual mandate and let the data guide our decisions.”
Acknowledging “anxiety about how the Federal Reserve is going to react” to economic optimism, Williams, an FOMC voter and possible nominee to become Fed Vice Chairman, said “I expect continued moderate growth, with no Herculean leap forward. So given that the economy’s performing almost exactly as expected, you can expect policymakers to do the same.”
Referring to the FOMC’s projections of three rate hikes this year, he said “we should stick to that plan. It will keep the expansion on track, prevent the economy from exceeding its potential by too much, and get interest rates back up closer to more normal levels.”
The same day, Chicago Fed President Charles Evans, who voted against the December rate hike, advocated a “pause” until mid-year, but said if inflation picks up, “then, we still could easily raise rates another three or even four times in 2018 if that were necessary. And I would support such a faster pace if the data point convincingly in this direction…..(R)aising rates more rapidly without derailing economic growth is clearly an option.
As heavy selling resumed Thursday, Philadelphia Fed President Patrick Harker, who voted for the December rate hike, said he was still “open to a March rate increase,” said he had “lightly penciled” in two 2018 rate hikes and said a third is possible depending on inflation and financial conditions
New York Fed President William Dudley dismissed the stock plunge as “small potatoes” relative to past gains and relative to a strong economic outlook. “As long as I am comfortable the economy continues to grow at an above-trend pace … I’m probably going to be supportive of removing monetary policy accommodation.” The Fed could do more than three rate hikes, he suggested.
Predicting “a strong year,” Dallas Fed President Robert Kaplan said Thursday he “doesn’t see this market adjustment spilling over into financial conditions,” though he’ll “be watching carefully.” He even said “more volatility in the markets, and maybe addressing some of the excesses and imbalances in the markets, by having a little more volatility, may be a healthy thing.”
Thursday night, Kansas City Fed President Esther George called monetary policy “quite accommodative,” not just because the funds rate “remains well below estimates of its longer-run value of around 3%” but because the Fed’s balance sheet “remains extraordinarily large by historical standards.”
“To sustain the expansion without pushing the economy beyond its capacity limits and creating inflationary pressures, it will be important for the Federal Reserve to continue its gradual normalization of interest rates,” she said.
In sum, officials have studiously avoided the panic shown by investors. The consistent message is that the market commotion does not change a fundamentally solid outlook.
A lot can happen between now and March 21, when the FOMC will vote on rates, but as of now there seems to be little inclination to refrain from raising the funds rate to a 1.5% to 1.75% range.