The market is thinking that a Jay Powell-led Federal Reserve will press ahead with rate rises, even if this means a fall in stock prices © Bloomberg
Jay Powell has introduced himself to the markets. And it looks like the markets did not like what they heard. If we go by Fed Funds futures prices, the odds of at least three rate rises this year, and of at least four, have both risen to a new high.
In both cases, the previous high came at the close of trading on January 31, the day of the last FOMC meeting. Since then, of course, stock markets have endured a sudden and brutal correction which has already been largely corrected. While that correction was going on, the bet was that there would be a “Powell Put”. In other words, the Fed under new ownership would blink, and would not have the guts to go through with raising rates if stock markets were in turmoil.
Now the market is back to thinking that the Powell-led Fed will press ahead with rate rises, even if this means a fall in stock prices. A sharp fall in stock prices on Tuesday barely altered the judgment of the Fed Funds futures market, and only slightly cut back the move in 10-year Treasury yields, which are back above 2.9 per cent.
What did Mr Powell say to drive this re-assessment? Markets did not make any particular move after his testimony was published, ahead of the hearing. Instead, the consensus, which I think is right, holds that the passage that moved the markets came early in his question and answer session with Representatives when Mr Powell displayed a degree of hawkishness that went slightly beyond the bare minimum he had to show to maintain his credibility.
This came via Mr Powell’s estimation that the case for four rate rises, rather than three (the median choice the last time the Fed published a dot plot, back in December) has increased in the past two months.
What it did not do was show any change in his “reaction function” when it comes to turbulence in the stock market. The big reaction in the stock market, and in the implicit odds put on rate rises, therefore tells us more about the market’s reaction function than it does about the Fed’s. The market has retained a cynical (or maybe realist) belief that when push comes to shove the Fed will not push up rates if this hinders the stock market, or threatens any kind of turbulence. That belief is now being challenged.
The debate on whether the Fed, and many other regulators in the financial and legal domain, were too timorous during and after the crisis has gone on for almost a decade already, and will doubtless endure for many decades more. The financial sector escaped with far less of a shake-up than many of us thought necessary in large part because regulators were scared to shake things up too much and precipitate a further crisis. In the case of the Fed, this lamentable state of affairs has arguably persisted since the Greenspan Fed decided to co-ordinate a bailout and then cut rates in the wake of the meltdown of the Long-Term Capital Management hedge fund in 1998. So it is wholly reasonable to think that it will continue.
But Janet Yellen, in her understated way, had already started to move away from this, actively reducing the Fed’s balance sheet and raising rates. Mr Powell is in many ways a blank piece of paper when it comes to monetary policy, despite his long history as a banker and Treasury official. Many seem to have assumed that this in effect would make him more likely to cave in to the concerns of the bankers and investors at the first sign of trouble. That proposition may yet turn out to be true, but he called such thinking into question on Tuesday.
Having a Fed chairman who understands the market, as many have put it, could be a double-edged sword. Mr Powell may be inclined, unlike an academic economist, to put an end to market nonsense earlier, and not be cowed by predictions of doom from the banks. On this view, worries about inflation may miss the point. The Powell Fed may wish to avoid becoming boxed in like the Greenspan Fed did when it prompted serious ructions in the fixed-interest market in 1994 (having arguably allowed speculation to go on too long) or when it felt obliged to bail out LTCM and the markets in 1998.
There is also a human aspect to this. The past three Fed governors all looked like academics and spoke like academics, albeit with often very different intonations. Mr Powell is in that sense different. He speaks rather more firmly and clearly than any of his three predecessors, and tended in his Q&A to be rather more declarative, avoiding the qualifiers that come naturally to an academic. At a subliminal level, this may have been uncomfortable for market-watchers; his rhetoric was not in any essential way any more hawkish than Ms Yellen’s had been for the past year, but he said it in a way that was uncomfortably business-like. This made an impression.
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