The summary of today’s FOMC statement along with Powell’s press conference remarks:
The Federal Reserve on Wednesday signaled it is likely to raise U.S. interest rates in March and reaffirmed plans to end its bond purchases that month before launching a significant reduction in its asset holdings.
Bond purchases = money printing. That’s the process of quantitative easing: the Fed prints money, then uses it to purchase bonds from large banks, who in turn loan the printed money out to whomever.
And when the Fed says it’s going to reduce its holdings, it means the opposite of money printing: reducing the money supply. The Fed then sells the bonds it purchased back to the banks and takes the proceeds (money) out of circulation.
The combined moves will complete a pivot away from the loose monetary policy that has defined the pandemic era and toward a more urgent fight against inflation.
In a press conference Fed Chair Jerome Powell said officials will discuss plans for reducing the central bank’s nearly $9 trillion balance sheet at their next two meetings, adding he expects there to be a “substantial” amount of shrinkage in the Fed’s bond holdings, which would reverse pandemic-era “quantitative easing that stabilized financial markets and the U.S. economy.
Wall Street reversed sharp gains during Powell’s comments.
This is a very, very important moment for the stock market. We are going into our first rate-hiking cycle in several years. Remember, interest rates were at zero from late 2008 all the way until late 2015–we have been in a low-rate environment for a very long time.
Even when the Fed did begin hiking in late 2015, rates only got as high as 2.5% by early 2019, which is still low in the grand scheme of things.
You can see that during the stagflation era of the late 1970s and early 1980s, interest rates were as high as 20%! That’s how aggressive the Fed was back then in combating inflation.
Since then, interest rates have gradually come down, and the rich have gotten richer accordingly.
The interest rate-stock market cycle is very important because it’s controlled by the Fed, and thus the Fed controls the market. That’s why people pay close attention when the Fed issues a statement.
The main thing to understand is that the Fed has a “dual mandate,” and it is to keep inflation stable (2%) and unemployment low. It must do those two things, and everything it does must be in pursuit of those two goals.
With this in mind, let’s summarize how the business cycle works in the United States. It’s easier to understand if you think of the various stages of the business cycle as analogous to the seasons of the year–summer, fall, winter and spring.
Here is the business cycle summarized:
- The economy is humming along, growing strongly, and unemployment is low. Interest rates are low to accommodate economic growth. (Summer)
- However, the economy begins running a bit “too hot,” and the Fed notices inflation is picking up. The Fed must not allow inflation to spiral out of control–and it will if left unchecked–so the Fed begins hiking interest rates in response to inflation. (Late summer)
- Rising interest rates succeed at arresting inflation, but only because economic growth itself has been arrested. With less borrowing and lending going on (e.g., to buy a home, start a business, expand an existing business, etc.), the economy stalls out and begins contracting. It is now in recession. Stocks begin collapsing as well and enter a bear market. (Fall)
- The recession causes a spike in unemployment as businesses, no longer making as much money as they were during the boom years, have to begin laying off employees to stay afloat. The Fed, seeing unemployment on the rise, springs into action and slashes interest rates in a desperate bid to jumpstart the labor market. (Winter)
- Eventually, it works. Unemployment ceases rising and begins declining, businesses start turning around–the economy is now in recovery, as is the stock market. (Spring)
- Soon, the economy begins booming again. We go back to step 1 and the whole process repeats itself once again.
That’s how it normally works. Well–that’s how it worked up until recently.
The Fed rate hiking cycle that’s about to begin in March is not due to an overheating economy, it’s due purely to inflation. The inflation we’re seeing now is caused by the massive amount of money that has been printed over the past 2 years, not by any sort of economic boom.
This is the Fed’s balance sheet going back 20 years:
Remember how we talked about the Fed printing money and buying bonds from banks, and that’s how quantitative easing works? Those bonds are held on the Fed’s balance sheet, so essentially what the Fed balance sheet tells us is how much money the Fed has printed and injected into the economy.
You can see that starting in 2008, when the economy was in freefall, the Fed began printing massive amounts of money all the way up to 2014. In 2018, it started to unwind its balance sheet (selling bonds). This caused the market to panic, and stocks plummeted in late 2018. In August 2019, the Fed began printing money at a slower rate, which caused the market to rally, but not long after, Covid-19 hit and the markets collapsed. The Fed then ramped up the money printing to 2008 levels and has been printing ever since. That’s where the inflation comes from.
Again, it’s not from any sort of economic boom. Money printing is the reason we’re seeing inflation.
Civilian labor force participation currently stands at 61.9%, well below the pre-lockdown level of 63.4%–and significantly lower than the pre-2008 peak of 66.2%:
The labor force participation rate tells you the real story–not the unemployment rate.
At any rate, we are now experiencing inflation levels not seen since the early 1980s, and accordingly the Fed is going to begin hiking interest rates to get inflation under control.
This hiking cycle will cause the market to retract, even if it does not immediately lead us into a recession. Stock valuations are near their all-time highs, and a lot of that is fueled by debt (i.e., margin purchases at low interest rates).
Higher interest rates negatively affect any person, business or government that is in debt, because it cost more to make interest payments on that debt.
This in turn means less capital available to be plowed into the stock market–as well as the economy overall.
The takeaway here is that as long as the Fed balance sheet is growing and interest rates are low, investors have the green light to buy stocks like crazy. But when the Fed ceases money printing and begins hiking interest rates, the stock market, and the economy itself, are in trouble.
This is why investors watch the Fed so closely and hang on the Fed Chairman’s every word.
With that said, we will turn to Zerohedge for analysis of the FOMC statement as well as Fed Chair Jerome Powell’s press conference remarks:
It started off well enough: milliseconds after the Fed statement and associated Fed balance sheet “principles” were released, algos quickly skimmed the key bullet points before they realized that there were no landmines in the statement: indeed, all the biggest hawkish fears had been defused with the Fed not announcing an early end to tapering, an early start to rate hikes and certainly nothing on the fears 50bps rate hike.
The Fed does its best to telegraph its moves in advance, because it doesn’t like to catch markets by surprise and cause volatility. You’ll see major moves in the market if investors see something unexpected in the Fed’s statement. News gets priced into the market very quickly–like almost instantly, meaning if you’re reading about something, it has already been priced into the market before you have time to react to it. That’s why ZH in the paragraph above talks about the “algos” scanning the Fed statement. Wall Street has computer programs that scan the news and instantly and automatically make investment decisions based on the news, and this moves markets faster than you or I could ever hope to react to. Markets already knew what the Fed was going to say, and so the FOMC statement was already priced into the market, which is why the market didn’t move much when the FOMC statement was released.
But if the Fed says something the market wasn’t expecting it to say, that causes volatility.
Drilling into the statement, the Committee announced the final two reductions in the amount of their monthly asset purchases, which will bring purchases to an end in “early March” and the Committee now expects that it will “soon be appropriate” to raise the funds rate – which will almost certainly happen at the next FOMC meeting in March—and updated the statement to note that inflation is “well above” the FOMC’s two percent target (previously characterized as “having exceeded 2 percent for some time”) and that the labor market is “strong,” dropping the judgment that the economy is short of full employment.
The Fed is moving on a very shortened timetable here. The last time they began hiking rates (late 2015/early 2016), QE had already been ceased for over a year. And they didn’t start unwinding their balance sheet until early 2018. Right now, the Fed is going to end QE in the next month or so, then hike rates a few weeks later, and then begin unwinding the Fed balance sheet in the early summer. There’s a clear sense of urgency here that the Fed is showing us. What was previously a 2+ year process is now being condensed into like 2-3 months.
Separately, the Committee released a new set of normalization principles for reducing the size of the Fed’s balance sheet. The principles state that balance sheet reduction will start “after the process of increasing the target range for the federal funds rate has begun,” implying that the Committee may decide to start normalization at any meeting after March. This contrasts with the previous cycle’s normalization principles, which stated that balance sheet reduction would begin “once normalization of the level of the federal funds rate is well under way.” While the Committee did not specify a pace for normalization, the principles note that the Committee intends to reduce the size of the balance sheet “primarily by adjusting the amounts reinvested of principal payments,” suggesting that active asset sales are unlikely as part of balance sheet reduction. The Committee also noted that it “intends to hold primarily Treasury securities” in its balance sheet over time.
So far so good, because there was nothing here that the market did not anticipate or had priced in.
And then Powell started talking… and all hell broke loose, as stocks, bonds, and gold all tumbled post-Fed as the dollar rallied.
This is the part markets were not expecting:
So what exactly did Powell say to upset the algos so much?
Well, a few things, starting with Biden’s admission that the Fed is launching the most historic tightening cycle with virtually zero visibility, when he said “the outlook is quite uncertain.”
Paradoxically, when it comes to the pace of rate increases, Powell was non-committal… which is not hawkish on its own. But as Bloomberg notes, the market may struggle on how to interpret that as the presumed pace is once a quarter. It could leave the door open to a more aggressive path than currently projected. But it could imply a readiness to pull back if downside risks were suddenly realized.
That represents uncertainty, and the market hates uncertainty.
That said, Powell apparently did have enough visibility to provide soft guidance: asked whether rate increases can undercut inflation without harming the labor market, Powell was optimistic, and issued a comment that immediately took the wind out of equity markets’ sails by signaling, inadvertently or not, a lengthier tightening cycle than expected: “I think there’s quite a bit of room to raise interest rates without threatening the labor market.”
A hint that the rate-hiking cycle may be fairly aggressive.
Powell continued his double-speak…
“[The] economy no longer needs sustained high levels of monetary support.”
BUT…
“Of course, the economic outlook remains highly uncertain.”
And for those hoping for the Fed Put, Powell curb-stomped that idea being anywhere near:
“Asset prices are somewhat elevated,” Powell says.
They don’t now pose a threat to financial stability, he says.
Inflation is clearly the Fed’s top priority right now. They don’t care about the stock market, and the unemployment rate is taking a backseat.
But the final straw was when Powell admitted that the Fed is “willing to move sooner” and “perhaps faster” than last time in shrinking the balance sheet. adding that “we want the balance sheet to be declining in a predictable manner,” by adjusting the reinvestment of maturing debt, to try to calm the panic.
The market is now expecting 5 rates hikes this year. Each rate hike is expected to be 0.25%, as usual, but there is some chatter that the Fed may hike 0.5% in March in order to show how serious it is about getting inflation under control.
Of course, the Fed is still currently printing money via QE, and will continue printing for the next 5-6 weeks or so, which is pretty crazy to think about. The Fed can be very unwieldy and slow, although of course it sprung into action almost immediately in March 2020.
So, this is where things stand as of now: one more month of money printing and then rate hikes.
However, if the market takes a dump over the next month or so, then we could see the Fed hold off on hiking even with inflation roaring. I really don’t know what to expect, because we have no idea what’s going to happen in the markets over the next month. But Powell seems like he’s determined to get inflation under control even if it tanks the stock market. I think that’s what he was communicating today, and that’s why the markets got spooked.