Fed officials have indicated that they’d rather see stock and bond prices fall than continue to rise, as they’ve been doing since October of last year. In their opinion, financial markets’ strength has eased financial conditions in the economy, offsetting some of their efforts to tighten financial conditions to bring inflation down.
Joe and I question their logic. In our opinion, the drop in bond yields since late last year and the increasing inversion of the yield curve are suggesting that the Fed’s monetary tightening policy is likely to work to bring inflation down without much further tightening. The same can be said about the stock market rally since October 12: It implies that investors believe that the federal funds rate is close to its terminal rate and that the Fed might succeed in bringing inflation down without causing a recession. If investors thought that the Fed’s tightening had already set the stage for a recession, bond yields would continue to fall and so would stock prices.
In effect, Fed officials have been reminding investors of the adage “Don’t fight the Fed.” Rhetorically speaking, the Fed heads have been fighting the markets’ optimism that the Fed can pull off a disinflationary soft landing. The Fed’s campaign to squelch such optimism started early this year. Consider the following:
(1) During his November 2, 2022 press conference, Fed Chair Jerome Powell mentioned “financial conditions” 10 times in the context that they were sufficiently tight. For example, he said, “Financial conditions have tightened significantly in response to our policy actions, and we are seeing the effects on demand in the most interest-rate-sensitive sectors of the economy, such as housing. It will take time, however, for the full effects of monetary restraint to be realized, especially on inflation.”
Powell said that in the past monetary policy worked with “long and variable lags” and that it worked first on financial conditions, then the economy, and “perhaps later than that even on inflation.” What he didn’t say is that very often in the past, Fed tightening triggered a credit crunch, which caused a recession that brought down inflation. In any event, he suggested that the lags might be shorter because “financial conditions react well before in expectation of monetary policy [actions].”
