On December 19, Jay Powell stepped to the microphone after the Federal Reserve had raised short-term interest rates and began his press conference. The market was concerned. The two-year rate on government bonds was at 2.65% and was higher than the 5-yr (2.62%) and inching perilously close to the 10-yr at 2.76%. The Fed typically inverts (raises short-term interest rates above long-term rates) the yield curve when it wants to slow the economy because inflation has begun to rear its ugly head. Just one problem. In December 2018 there was no surge of inflation. In fact, the TIPs market said inflation would be below the Fed’s 2% for 10 years.
All of this begged the brilliantly on-point query by Jeanna Smialek of Bloomberg, and I paraphrase: “If you haven’t achieved your two percent inflation goal for 10 years and you don’t see it overshooting, what’s the point of raising rates again at all?” Powell hedged and said policy at this point “does not need to be accommodative”. The market basically crashed for the next week as everyone took that to mean we will continue to raise rates and shrink the balance sheet. Or to paraphrase Ben Bernanke: “We the Fed will murder this economy!”
The Bloomberg Financial Conditions Index, which measures the overall level of financial stress, plummeted. All risk assets were harmed- equities, credit spread products, and commodities. Market participants, including myself, were shocked that the Federal Reserve would “murder” an economy showing no signs of inflation. The Fed was, in fact, achieving its sometimes-contradictory dual mandate – strong employment and stable prices. Instead of smiling and taking a victory lap, Powell felt the need to get way ahead of the data. Fortunately, it wasn’t a plan. It was a rookie mistake.
So how do I know for sure? Immediately after the pre-Christmas debacle, all the Fed governors, including Chairman Powell, walked further rate increases back and, furthermore, even hinted at slowing or stopping the pace of balance sheet shrinking. This culminated in his January 30th press conference where he stated, the Fed is now in “a wait and see approach” and the case for “raising rates has weakened”. I have followed the Fed for a long time, and I can never remember a bigger 180-degree turnaround in one month. The risk markets have noticed. The stock market is on an upward tear along with high yield bonds and other risk assets.