The Federal Reserve was so worried about not being hawkish enough that policymakers probably went overboard. The Fed emerged from Wednesday's meeting with all guns blazing: rapid-fire 75-basis-point rate hikes, more hawkish forward guidance and an unprecedented pace of balance-sheet tightening. The barrage has spiked Treasury yields to their highest level in more than a decade and the U.S. dollar index to a 20-year peak, while sending the S&P 500 tumbling near bear market lows.
That's an awful lot of stress to put on financial markets at any time. But the current global economic foundation seems especially brittle as central banks battle inflation; Russia wages military war against Ukraine and economic war against Europe; China struggles amid lockdowns and a hangover from a real estate boom; and governments are saddled with high debt levels that were further inflated by the pandemic.
Summer Rally Boxed In The Fed
Yet the Fed entered last week's pivotal meeting with one goal: quashing any possible signal that would allow financial conditions to ease and the S&P 500 to rally.
By all accounts, the Fed had been caught off-guard by the financial market rally that followed its 75-basis-point hike on July 27. Building on a rally off mid-June lows, the S&P 500 had surged 17% by mid-August. The 10-year Treasury yield had backtracked nearly a full point over a six-week period.
Federal Reserve policymakers took umbrage at that rally, which seemed to cast doubt on their resolve to tame inflation. The consequence of thawing financial conditions this summer became all too clear with last week's CPI report. A far-too-strong job market is still keeping inflation way too high. While the overall inflation rate eased to 8.3%, prices for core services, such as rent, health care and transportation, rose 0.6% on the month and 6.1% from a year ago, the fastest pace since February 1991.
Federal Reserve Message Correction
The summer rally began to come undone on Aug. 26, when Fed chief Jerome Powell, in his Jackson Hole, Wyo., speech, ditched his earlier optimism that the U.S. economy could skirt recession. Instead, Powell signaled that the Fed will keep policy tighter for longer, grounding the economy so that the current inflation outbreak doesn't turn into a chronic 1970s-style disaster.
Powell's speech began a market repricing of the Fed policy outlook, undoing the dovish impression he gave with his July 27 news conference that had helped the S&P 500 cut its 24% loss by more than half, exiting a bear market.
August's hot CPI reading jolted market interest-rate expectations still higher. As a result, the Fed's hawkish policy signals on Wednesday mostly just confirmed the bad news Wall Street was already expecting. A third-straight 75-basis-point rate hike was fully priced in. Markets already had priced in odds slightly above 50% that the key federal funds rate would rise to a range of 4.25%-4.5% by the end of 2022 and reach 4.5%-4.75% in 2023.
No Fed Put For The S&P 500 — Or Global Economy
So why the harsh market fallout since Wednesday's Fed meeting? The tenor of the meeting ensured that investors won't doubt the Fed's resolve again. Markets now expect another 75-basis-point hike Nov. 2 and another half-point move in December. That's coming as the Fed has doubled the pace of balance-sheet tightening to as much as $95 billion per month — nearly twice the $50 billion monthly rate that helped trigger a market meltdown and near bear market for the S&P 500 in late 2018.
Back then, inflation was too low, not too high, so Federal Reserve policy turned on a dime. Policymakers shelved their plan for a series of rate hikes to guard against the possibility of higher inflation. Balance-sheet tightening slowed, then stopped. By the fall of 2019, the Fed had begun cutting rates and buying up more assets. This time around, there's little hope for a Fed reprieve until markets get much uglier.
The bigger problem may be that the tightening isn't happening in a vacuum, but is creating waves in interconnected financial markets across the globe. As Treasury yields spiked following the Federal Reserve meeting, so did the U.S. dollar vs. foreign currencies. That provoked Japan to intervene to prop up the yen for the first time since 1998. Other currencies, including the euro and British pound also are breaching key long-term support levels vs. the dollar.
When the Fed's need to tighten to meet its domestic inflation mandate creates problems for the rest of the world, markets can quickly come unglued, as they did in early 2016 and late 2018. In both cases, the Fed quickly pivoted away from aggressive tightening plans. This time will be different.
The World's Central Bank
The Fed is sometimes regarded as the world's central bank, partly because the dollar is the world's reserve currency and key commodities such as oil are priced in dollars.
While the strong dollar will help tame inflation in the U.S. by lowering the price of imports, it will deepen problems for other countries struggling with inflation. A number of foreign central banks followed the Fed's big hike on Wednesday with their own bigger-than-expected hikes on Thursday. But pushing up interest rates and weakening their economies can worsen debt sustainability issues, pressuring currencies.
Back on March 2, just after Russia's invasion of Ukraine, Powell told Congress that he would support a quarter-point rate hike at the coming meeting, not a half-point. "We will use our tools to add to financial stability," Powell said. "We're going to avoid adding uncertainty to what is already an extraordinarily challenging and uncertain moment."
It's not clear that the Federal Reserve struck the right balance this week.
S&P 500 On A Knife's Edge
A soft September jobs report on Oct. 7 and less-troubling CPI reading a week later could potentially provide a respite for markets. But next week may be a wild ride.
After sliding 9.2% over the past two weeks, the S&P 500 is now down 23% from its all-time closing high on Jan. 3 and just 0.7% above its June 16 closing low. The Nasdaq composite is also close to its June lows, while the Dow Jones did hit a 22-month low on Friday.
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