Is the Fed ignoring market risk?

Good morning. It looks like the US is in a manufacturing recession. Yesterday’s ISM manufacturing report showed the sector shrinking for the third straight month, and the ISM index has dipped below where it bottomed in recent non-recessionary downturns, such as 2015-16. The contrast with the consumer side of the economy is striking. Email us your thoughts: robert.armstrong and ethan.wu.

Shameless plug: Armstrong is the guest on this week’s Behind the Money podcast. Listen in and subscribe!

The Fed vs markets

Neither Federal Reserve chair Jay Powell’s press conference yesterday, nor the official statement that preceded it, held many surprises. Both acknowledged that disinflation has begun in earnest, that growth is slowing, but that “ongoing increases” in interest rates are nonetheless likely. In the presser, Powell sounded measured. He cheered on disinflation while cautioning that the process was at an early stage. The Fed, he added, is still holding out for “substantially more evidence” that inflation is coming down for good. Asked if it was time to halt rate increases, Powell pushed back:

Why do we think [a couple more rate hikes are] probably necessary? Because inflation is still running very hot . . .

We don’t see [higher rates] affecting the services sector ex-housing yet. Our assessment is that we’re not very far from that [appropriately restrictive] level. We don’t know that, though . . .

I think policy is restrictive. We’re trying to make a fine judgment about how much is restrictive enough.

Markets looked indecisive after the statement came out, but took the press conference as dovish. The policy-sensitive two-year yield dropped some 13 basis points in the half-hour Powell was speaking. The Nasdaq closed up 2 per cent.

What struck us most was Powell’s calm, almost blasé attitude towards the wide gap between markets’ rate expectations and Fed’s policy guidance. Futures markets are pricing in roughly 50 bps of rate cuts by the end of 2023, leaving the policy rate at 4.4 per cent, an outlook which did not budge after the meeting. The Fed, in December, said it expected rates to end the year at 5.1 per cent. Questioned about the mismatch, Powell said:

I’m not particularly concerned about the divergence, no, because it is largely due to the market’s expectation that inflation will move down more quickly. Our forecasts, generally, are for continued subdued growth, some softening in the labour market, but not a recession. We have inflation moving down to somewhere in the mid-3s . . . 

Markets are past that. They show inflation coming down much quicker than that. So we’ll just have to see. We have a different view, a different forecast, really. And given our outlook, I don’t see us cutting rates this year, if our outlook turns true. If we do see inflation coming down much more quickly, that’ll play into our policy-setting, of course.

In other words, Powell sees inflation moderating without plummeting, meaning rates will stay high. Markets see inflation dropping like a rock, pushing the Fed to cut.

Is Powell right to be unbothered? His remarks yesterday emphasised how much tighter financial conditions are today than, say, a year ago, while playing down the importance of “short-term moves” in the markets. The chart below, of the Chicago Fed’s financial conditions indicator, shows both the marked tightening since mid-2021 and the extent of recent loosening:

The most persuasive argument for Powell’s nonchalance is that, by all indications, monetary policy is working as intended, if slowly. Demand, wage growth and inflation are all cooling off. Mortgage rates have fallen 100bp from their peak, but that still leaves them 350bp higher than in 2021. This is having the hoped-for effect on the real economy; existing-home sales fell 38 per cent in 2022, for example. That broad story — off a peak but plausibly restrictive — holds for bond yields and credit spreads, too. The recent loosening isn’t ideal but if policy is working, why worry about what the market expects?

The case against Powell’s nonchalance about the gap hinges on credibility. This is a vague concept, but Unhedged defines it simply: it is the ability of a central bank to jawbone the market. It is important that the central bank can change financial conditions just by talking about policy, as opposed by actually enacting policy, especially for keeping inflation expectations anchored.

The idea that Powell is putting his credibility at risk by looking past the Fed-market gap comes down to the idea that market conditions are undercutting central bank policy. High stock prices and tight bond spreads are inflationary; they make more capital available to companies, make households feel richer, and so on. Powell, therefore, should further tighten policy, bringing markets to heel (Richard Bernstein recently made this sort of argument in the FT; Mohamed El-Erian presented a different version on Bloomberg.)

Credibility, though, cannot be established by posturing or signalling. It is the product of consistently having the correct policy. It would be absurd to suggest that the Fed should build its credibility by pursuing a policy that is wrong for employment or price stability. So Powell has to choose a rate level that he thinks will get financial conditions to the right place at the right pace. An optimistic market is a consideration determining the right policy rate, because it loosens financial conditions. But the market’s failure to mirror the Fed’s inflation outlook is not a reason, over and above financial conditions, to tighten policy in the name of credibility.

That said, we are worried about the Fed-market gap, not because of credibility but because of market risk. Suppose the Fed is right and the market is wrong, and the path to lower inflation does not run smooth. Say in a few months we get some bad news on inflation, forcing the market to move its estimate for the peak policy rate up and extend its expectations for how long high rates will last. That could lead to a very large, very fast repricing in markets.

Remember that the S&P 500 is 15 per cent off its lows of October, while junk bond spreads have tightened by a full percentage point. If that were to reverse all at once, as the economy was already shrinking, that could easily turn what might otherwise have been a mild recession into a severe one. This does not strike us as a particularly unlikely scenario, simply because inflation tends to be volatile and markets are very jumpy about rates right now.

Is it Powell’s job to control market risk? Should he target lower stock and bond prices directly? We’re not sure, and are very interested to hear readers’ thoughts. (Armstrong & Wu)

Mark Zuckerberg gets the message

Meta reported earnings after the close yesterday. Revenue was a little better than expected, but the big news was meaty cuts to the outlook for operating expenses in 2023 (from $97bn at the midpoint to $92bn) and capital expenditure (from $35.5 to $31.5bn).

In the conference call, Zuckerberg said 2023 would be “the year of efficiency” at Meta and said his goal was to make the company not just stronger but more profitable.

The stock, already up 3 per cent on the day, rose another 19 per cent in after-hours trading, The shares have now doubled (doubled!) from its November lows, when it looked like expenses were rising fast while revenue set to fall. Back then I wrote:

If Zuck can cool it [on expenses] my guess is that Meta shares have a lot of upside — so long as the company’s digital ad sales slowdown doesn’t get much worse. I have no idea about this. Of course this is all very crude (“Just spend less money and talk like a grown-up and the stock will go up!”) but some problems have crude solutions.

Have my dreams come true? Maybe. The cost cuts are good news, but put them in perspective. Operating expenses in 2023 are still set to be 30 per cent higher than they were two years before; capital expenditure, 30 per cent higher. No one is going to start calling him ‘Mark the knife’.

On the earnings call yesterday, one analyst asked exactly the right question: in years to come, is the plan for expenses to rise in line with revenues, or is the company still in margin-compression mode? Slightly alarmingly, the CFO gave a vague answer, pointing to expectations of “compounding earnings growth” over time.

Meta, at its lows, traded at 11 times forward earnings estimates, a huge discount to the market. Now, at 22, it is at a small premium, despite cloudy prospects for earnings growth. Readers can come to their own conclusions.

One good read

I missed it when it came out last spring, but this detailed account of how social media feeds political polarisation, from the social psychologist Jonathan Haidt, is a must-read for Facebook investors (and probably the rest of us too).