‘The Ultimate Negative Feedback Loop’

Why did the Fed hike into a backdrop characterized by lackluster inflation prints?

The easy answer is that the committee is siding with the labor market in the “who you gonna believe” juxtaposition between full employment and below target inflation.

That’s probably not what’s really going on and if there is some truth to that explanation then it doesn’t tell the whole story.

More likely, the Fed is unnerved at the extent to which multiple rate hikes have failed to tighten financial conditions which, you’re reminded, have gotten easier and easier since early 2016 (one tightening episode just prior to the election notwithstanding):

FCI

(Goldman)

This has of course encouraged further speculation in risk assets and is part and parcel of record high equity prices.

Over the past several weeks, we’ve gotten some rather explicit commentary from Fedspeakers suggesting they are indeed concerned with this. You should check out Kevin Muir’s take here for some examples and for an in-depth discussion of the “third mandate.”

Just how much do financial conditions matter in terms of blowing bubbles? Well, the following chart suggests that the correlation is now almost perfect…

AllWorldVsFCI

(BofAML)

So what does that mean for central banks?

Well, it means that if they want to curb risk taking, they’ll do what the Fed did and tighten policy even if that means “looking through” still low inflation.

Of course it also means they have to be careful to avoid triggering a collapse. As BofAML writes on Monday, “with asset prices so well correlated to financial conditions now, being too hawkish – and instigating market tantrums – creates the ultimate negative feedback loop.”

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