Federal Reserve’s ‘Whatever It Takes’ Pledge Highlights Risks For S&P 500, U.S. Economy
Federal Reserve chief Jerome Powell’s vow on Wednesday to rein in inflation was, in the view of Jefferies economics team, his “whatever it takes” moment, akin to central banker Mario Draghi’s pledge to save the euro. The Fed’s plan for seven rate-hikes this year — a few more than Wall Street expected — initially led the stock market rally to falter. Yet Powell’s bullish outlook for the U.S. economy propelled the S&P 500 to session highs on Wednesday.
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In Thursday’s stock market action, the S&P 500 and other major indexes tacked on further solid gains. The S&P 500 and Dow Jones rose 1.2%, while the Nasdaq popped 1.3%. Tentative progress in Russia-Ukraine negotiations also may have helped whet investors’ risk appetite. Still, it’s worth a closer look at the Federal Reserve’s policy signals. Should they really make investors bullish about the coming weeks and months?
This was the key line in Powell’s post-meeting press conference: “The plan is to restore price stability while also sustaining a strong labor market. That is our intention, and we believe we can do that. But we have to restore price stability.”
Left unsaid: The Fed won’t shy away from pushing up unemployment, if necessary, to prevent high inflation from becoming a chronic problem for the U.S. economy.
Getting control of inflation should be good for the S&P 500 and stock market in the longer run. But the short run could still be rocky.
At Least Seven Federal Reserve Rate Hikes
In discussing the path of the U.S. economy this year, Powell indicated that risks tilt to inflation running even higher than expected.
Russia’s invasion of Ukraine will likely add “upward pressure on inflation and weigh on economic activity,” the Fed policy statement said. The Feb. 24 attack fueled price spikes for a broad range of commodities, including oil, aluminum, nickel, wheat and fertilizer, amid actual and potential supply disruptions.
China’s biggest Covid flare-up since the original Wuhan outbreak also poses upside inflation risk amid lockdowns in key manufacturing hubs. It also could weigh on global growth.
Powell acknowledged that, in hindsight, the Fed “obviously” should have moved to tighten policy earlier, and now must play catch-up.
The Fed is set on “getting rates back up to more neutral levels as quickly as we practicably can and then moving beyond that, if that turns out to be appropriate,” Powell said.
In other words, Federal Reserve policymakers will hike more than 1.75 percentage points — seven quarter-point moves — this year, if they feel they can do so without tanking the economy. There are only six meetings left. However, markets are pricing in 33% odds of a half-point hike at the May 3-4 meeting, according to CME Group’s FedWatch page.
Powell’s wording also implies that the Fed may hike more than seven times this year — regardless of risk to the U.S. economy — if policymakers think it’s necessary to contain inflation risk.
Actually, it may be more accurate to say that the Fed already plans eight rate hikes this year. “Shrinkage of the balance sheet,” Powell said, “might be the equivalent of another rate increase.”
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No Powell Put For S&P 500
On Wednesday, the Fed said it would begin to pare back asset holdings “at a coming meeting.” The U.S. central bank bought $4.5 trillion in Treasuries and government-backed mortgage securities starting in March 2020.
As those bonds reach maturity, the Fed will no longer reinvest all the principal. Instead, some of those assets will run off the balance sheet.
Federal Reserve asset purchases, most observers agree, have a positive impact on stock prices. Fed buying of low-risk government securities holds down interest rates, encouraging risk-taking and underpinning stock valuations. The reverse process, dubbed quantitative tightening (QT), is therefore a headwind for stocks.
Back in September 2018, as the Fed hiked rates and shrunk its balance sheet, Powell addressed what might prompt a policy change. Powell set the bar at a “significant correction and lasting correction in financial markets.”
Only after the S&P 500 selloff reached 20%, flirting with bear market territory, did Powell and his colleagues do an about-face. The Fed slowed balance-sheet runoff in early 2019. By August, the Fed started cutting rates.
Given Powell’s determination to rein in inflation, it’s doubtful that a bear market would prompt a near-term policy shift. The Nasdaq composite is now 16% off its record high. This week’s rally lifted the tech-heavy index out of bear-market territory. Meanwhile, the S&P 500 stands 9% below its peak and the Dow Jones industrial average has lost 7%.
The point isn’t that recession for the U.S. economy and a bear market for the S&P 500 are certain. Yet risks abound, and the Fed is unlikely to come to the rescue unless and until what Powell calls “the real economy” — not just financial markets — are showing signs of distress.
Powell’s ‘Painless Path’
Deutsche Bank chief U.S. economist Matthew Luzzetti titled his note on the Fed meeting, “A painless path to price stability?”
Both Powell’s comments and policymakers’ quarterly economic projections suggest Fed committee members are sanguine about prospects for being able to rein in inflation and maintain a strong labor market.
That upbeat view seemed to carry the day among investors. Yet Luzzetti doesn’t share their optimism. He sees greater odds that price stability will only come “with a more significant reduction in growth and an increase in unemployment, consistent with heightened recession risks beyond this year.”
Please follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.
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