Is the Fed finally in control? Markets think so—at their peril
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2 min read . Updated: 02 Jun 2022, 06:56 PM IST The belief that central banks can closely control inflation and growth remains a dangerous one
Investors may be giving central banks too much credit—or blame—for whatever happens to inflation.
Stocks remain volatile even after late May’s relief rally, showing a tight inverse link with indicators of global financial conditions such as Treasury yields, corporate-debt spreads and demand for the U.S. dollar. Pessimists see a recession coming, as often happens when the Federal Reserve raises interest rates, whereas optimists think the central bank can hit a sweet spot to balance inflation and economic growth.
Inflation markets appear to side with the latter.
In periods of high inflation, central-bank policy can’t be understood through rates or bond yields alone. A popular gauge of “real" U.S. financial conditions are yields on inflation-protected Treasurys. In March and April, these were still negative even as regular yields climbed, implying that investors saw future inflation going higher because they didn’t find the Fed’s hawkish stance aggressive enough.
But then inflation expectations started a steady decline, as a trickle of data released in May pointed to a slowdown in parts of the economy—the housing market, for example. U.S. inflation for April came in at 8.3%, from March’s 8.5%, raising hopes of a peak.
“The Fed has already done the job of pushing monetary policy to neutral," said AXA Investment Managers fund manager and inflation-market connoisseur Jonathan Baltora. He prefers to look at short-term inflation-adjusted rates which, as they rose, damaged stocks. But they have now settled around 0%, suggesting the adjustment may be over and that markets have learned to see the Fed’s stance as broadly on point.
If the market is pricing all this correctly, it shouldn’t bode too ill for stocks, even if uncertainty keeps them volatile. Unadjusted for inflation, interest rates would peak around 3%, which is close to what happened in the prepandemic bull market, when there was no alternative to embracing risk. And while the economy is slowing and corporations’ earnings guidance is turning more negative, figures published Wednesday confirmed that the labor market remains robust.
But investors’ newfound confidence in the Fed raises an oft-neglected question: Do central banks truly possess this kind of granular control over inflation and growth?
The post-2008 period belies this notion, as does the current bout of inflation. In the eurozone, where fiscal stimulus was much tamer, inflation came in this week at a record 8.1%. U.S. rate policy can’t have a big impact on global phenomena fueled by pandemic and war-related shortages—save perhaps through a savage tightening to 1980s levels. Inflation could as easily fall from here as jump again. Either way, the Fed could matter little. Nor will it have much say over the longer-term impacts of bringing supply chains onshore and transitioning to green-energy production.
But rates do affect stocks, and a central bank that reacts without much actual power is bad news for them, even without a recession. If inflation slows from here, rates will be given credit for it and be left higher than perhaps necessary. Equities may still be the only attractive investment, but valuations remain historically elevated even after the latest selloff, and governments’ appetite for activist fiscal policy has diminished.
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Conversely, higher inflation in the second half of the year could lead to exaggerated fears that this will be permanent. China’s latest lockdowns are a clear example of how supply disruptions may still drag on.
The illusion of being in control can bring comfort, but it is a dangerous one.