So far the bet of the Fed.
“‘It is difficult to know how much the US Federal Reserve will have to do to control inflation. But one thing is certain: to be effective, it will have to inflict more losses on stock and bond investors than it has ever done before.””
That is William Dudley, the former president of the powerful New York Fed, arguing in a guest column on Bloomberg that his former colleagues will not control inflation, which is hovering around a 40-year high, unless they make investors suffer.
There are myriad uncertainties for the Fed to navigate, he acknowledged, including the effect of easing supply chain disruptions and a historically tight labor market. But the effects of the Fed’s monetary policy tightening on financial conditions, and what effect the tightening will have on economic activity, is one of the biggest unknowns, Dudley wrote.
Unlike many other economies, the US doesn’t respond directly to changes in short-term interest rates, Dudley said, in part because most US buyers have long-term, fixed-rate mortgages. But many US households, also in contrast to other countries, hold a significant portion of their wealth in stocks, making them sensitive to financial conditions.
Dudley’s call for the Fed to inflict losses on investors contrasts with the long-standing notion of a figurative Fed put option, the idea that the central bank would stop monetary tightening or come to the rescue in the event of large losses. in the financial markets. Dudley, who led the New York Federal Reserve from 2009 to 2018, was chief US economist at Goldman Sachs and is now a senior fellow at Princeton University’s Center for Economic Policy Studies.
Investors have talked about a figurative Fed put option since at least the October 1987 stock market crash that prompted the Alan Greenspan-led central bank to lower interest rates. An actual put option is a financial derivative that gives the holder the right, but not the obligation, to sell the underlying asset at a certain level, known as the strike price, which acts as an insurance policy against a market decline.
Stocks have lost ground in 2022, partly in reaction to signals from the Fed that it is prepared to be aggressive in raising interest rates and shrinking its balance sheet to rein in inflation. But losses remain modest, with the S&P 500
down less than 7% from its record close from January 3 to Tuesday’s close. The Dow Jones Industrial Average
is down 5.1% so far this year, while the Nasdaq Composite
made up of more rate-sensitive growth and technology stocks, it is down more than 11%.
The pain has been most intense in the bond market. Treasury yields, which move in the opposite direction of prices, have soared, albeit from historically low levels. First-quarter losses in the bond market were the worst in a quarter century.
Still, the 10-year Treasury yield
above 2.5% remains about only 0.75 percentage point from a year earlier and remains well below the rate of inflation, Dudley said. That’s because investors expect higher near-term rates to undermine economic growth and force the Fed to reverse course in 2024 and 2025, he said, “but these same expectations are preventing the tightening of financial conditions that would make that outcome more likely.”
Investors should listen to Fed Chairman Jerome Powell, said Dudley, who has clearly stated that financial conditions need to be tightened.
“If this doesn’t happen on its own (which seems unlikely), the Fed will have to shock the market to get the desired response,” Dudley said. That would mean raising rates much more than market participants currently anticipate because the Fed, “one way or another, to control inflation … will need to push bond yields higher and stock prices lower.” the low”.