Is the Fed ignoring market risk?

Hello. It looks like the US is in a manufacturing recession. Yesterday’s ISM manufacturing report showed the sector contracting for the third consecutive month, and the ISM index fell below its lowest level in recent non-recessive recessions, such as in 2015-2016. The contrast with the consumer side of the economy is striking. Email us your thoughts: [email protected] and [email protected]

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

The Fed versus the markets

Neither Federal Reserve Chairman Jay Powell’s press conference nor the official statement that preceded it held many surprises. Both acknowledged that disinflation has started in earnest, that growth is slowing, but that “continued increases” in interest rates are nonetheless likely. In the presser, Powell looked measured. He encouraged disinflation while warning that the process was only just beginning. The Fed, he added, is still waiting for “much more evidence” that inflation is coming down for good. When asked if it was time to stop the rate hikes, Powell replied:

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

We do not see [higher rates] further affecting the non-residential services sector. Our assessment is that we are not very far from [appropriately restrictive] level. We don’t know that, however. . .

I think the policy is restrictive. We try to make an accurate judgment on what is restrictive enough.

Markets seemed undecided after the statement was released, but viewed the press conference as dovish. The policy-sensitive two-year yield fell some 13 basis points in the half hour Powell spoke. The Nasdaq closed up 2%.

What struck us most was Powell’s calm and almost jaded attitude to the wide gap between market rate expectations and Fed policy guidance. Futures markets are pricing in rate cuts of around 50 basis points by the end of 2023, leaving the key rate at 4.4%, a prospect that remained unchanged after the meeting. The Fed in December said it expected rates to end the year at 5.1%. Asked about the mismatch, Powell said:

I’m not particularly concerned about the divergence, no, because it’s largely driven by the market’s expectation that inflation will come down faster. Our forecasts, in general, call for moderate and continued growth, some slowdown in the labor market, but not a recession. Inflation drops somewhere in the mid-3s. . .

The markets are passed. They show that inflation is falling much faster than that. So all that remains is to see. We have a different point of view, a different forecast, really. And given our outlook, I don’t see us cutting rates this year, should our outlook materialize. If we see inflation come down much faster, that will of course play into our policy.

In other words, Powell sees inflation moderating without falling, which means rates will stay high. Markets see inflation dropping like a rock, prompting the Fed to cut.

Is Powell right not to be bothered? His remarks yesterday underscored how tighter financial conditions are today than, say, a year ago, while downplaying the importance of “short-term moves” in the markets. The chart below, of the Chicago Fed’s Financial Conditions Indicator, shows both the sharp tightening since mid-2021 and the extent of the recent loosening:

The most compelling argument for Powell’s nonchalance is that, by all indications, monetary policy is working as expected, albeit slowly. Demand, wage growth and inflation are slowing. Mortgage rates are down 100 basis points from their peak, but that still leaves them 350 basis points higher than in 2021. This is having the intended effect on the real economy; sales of existing homes have fallen 38% in 2022, for example. This broad story – off a peak but plausibly restrictive – also applies to bond yields and credit spreads. The recent easing isn’t ideal, but if the policy is working, why worry about what the market expects?

The argument against Powell’s nonchalance about the discrepancy hinges on credibility. It’s a vague concept, but Unhedged defines it simply: it’s the ability of a central bank to strangle the market. It is important for the central bank to be able to change financial conditions simply by talking policy, rather than actually enacting policy, especially to keep inflation expectations anchored.

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

Credibility, however, cannot be established by posturing or signals. It is the product of consistently having the right policy. It would be absurd to suggest that the Fed should build its credibility by pursuing a policy that is bad for jobs or price stability. Powell must therefore choose a rate level that he believes will bring financial conditions to the right place and at the right pace. An optimistic market is a determining consideration for the right policy rate, as it eases financial conditions. But the market’s inability to reflect the Fed’s inflation outlook is no reason, beyond financial conditions, to tighten policy in the name of credibility.

That said, we are concerned about the gap between the Fed and the market, not for credibility reasons, but because of market risk. Suppose the Fed is right and the market is wrong, and the path to lower inflation is not smooth. Suppose that in a few months we receive bad news on inflation, forcing the market to raise its estimate of the maximum key rate and extend its expectations for the duration of high rates. This could lead to a very significant and very rapid revision of market prices.

Remember that the S&P 500 is 15% off its October lows, while junk bond spreads have tightened by a full percentage point. If this were to reverse all of a sudden, when the economy was already contracting, it could easily turn what would otherwise have been a mild recession into a severe one. This doesn’t strike us as a particularly unlikely scenario, simply because inflation tends to be volatile and markets are very nervous about rates at the moment.

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

Mark Zuckerberg gets the message

Meta reported earnings after yesterday’s close. Revenues were a little better than expected, but the big news was a substantial reduction in the outlook for operating expenses in 2023 (from $97 billion at the midpoint to $92 billion) and capital expenditures (from 35.5 to 31.5 billion dollars).

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

The stock, already up 3% that day, rose another 19% in after-hours trading. Stocks have now doubled (doubled!) from their November lows, as it looked like spending was rising rapidly while revenues were set to fall. . At the time I wrote:

If Zuck can chill it [on expenses] I guess Meta stocks have a lot of upside – as 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 an adult and stocks will go up!”) but some problems have crude solutions.

Did my dreams come true? May be. Cost reductions are good news, but put them in perspective. Operating expenses in 2023 are still expected to be 30% higher than two years ago; capital expenditure, 30 percent more. No one is going to start calling it ‘Mark the knife’.

On the earnings call yesterday, an analyst asked exactly the right question: In the coming years, is the plan to increase spending in line with revenue, or is the company still in margin compression mode? Slightly alarmingly, the CFO gave a vague response, underscoring expectations of “cumulative earnings growth” over time.

Meta, at its lowest, was trading at 11x forward earnings estimates, a huge discount to the market. Now, at 22, that’s at a small premium, despite an unclear earnings growth outlook. Readers can draw their own conclusions.

A good read

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