In mid-January, well before the recent turmoil in financial markets, I wrote that although it is hard to bet against equities in the midst of an economic expansion, stock markets felt frothy, with excessive gains in recent months.
That would have been a good market-timing call. A period of steady, good economic news, including data on US wages that raised fears of a more aggressive Federal Reserve in the months ahead, helped trigger a shift in market psychology. The sell-off that began Feb. 2 turned into a rout on Monday. Not a particularly welcome event for the new Fed Chair, Jerome Powell.
What’s next? At this point, it is premature to change the fundamental outlook for monetary policy or the economy. We need to see more upheaval in financial markets before either becomes likely. While the declines in recent days were unsettling, they need to be taken in context. First, they followed a long period of remarkably tranquillity. Equities rose relentlessly for months; only a fraction of those gains have been reversed. A correction wasn’t completely unexpected in this environment.
Second, we have not experienced the same degree of interplay between asset prices and the economy as in the last two cycles. In each of those, frothy asset prices clearly drove very specific excesses in investment activity, first in information technology, then in housing. In comparison, the current expansion is much more broad-based, with no obvious indications of excessive activity in any one sector. And overall, growth has been tepid compared to the past two recessions.
This time around, the activity on Wall Street remains largely separate from Main Street. The latter is benefiting from a very real cyclical upswing that encompasses almost the entire globe. That dynamic won’t shift on the back of declines on Wall Street to date.
This cyclical upswing supports the Fed’s plan to hike rates three times this year. That also hasn’t changed. Central bankers will repeat that they are watching financial markets and are prepared to act if the troubles there look likely to spill over to the broader economy.
Fed officials will be loath to halt their tightening campaign. The pace of economic activity appears likely to continue to place downward pressure on an unemployment rate they believe is already at a level beyond full employment. Moreover, inflation seems to have firmed in recent months, raising hopes that the Fed’s inflation forecast will be reached this year. For Powell and other policymakers, backing off their rate hike forecast now only increases the risk that they will fall behind the curve and will need to accelerate the pace of rate hikes later. They will see such an acceleration this late in the cycle as the perfect recipe for recession.
This doesn’t mean the market sell-off doesn’t affect policy. Expectations of a fourth rate hike this year had been growing in recent weeks. Frothy financial markets contributed to this expectation as they indicated that rate hikes removed little if any financial accommodation to date. Clearly, more volatile conditions on Wall Street along with more tepid gains weighs against the possibility of a fourth increase.
All of the above holds only if the turmoil on Wall Street does not broaden into a greater disruption. Sufficiently deep declines in asset prices, especially if they seem to become a systemic event with broad implications for financial firms, will be met with a more forceful response by the central bank.
The Fed will move in four stages. First, calming voices reminding us that policy is data dependent. Second, a delay to scheduled rate hikes. Third, a downward revision to the rate hike forecast. And finally, a rate cut. So far, I think we are only at the first stage. Further declines on Wall Street will be needed before moving to stage two and beyond.
Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy’s Fed Watch.