“The continuing global recovery faces multiple challenges as the pandemic enters its third year,” the IMF’s Gita Gopinath said Tuesday, in an editorial accompanying the Fund’s latest World Economic Outlook, which featured downward revisions to growth forecasts and upward revisions to inflation projections.
She exhorted policymakers to stay vigilant, keep apprised of the incoming data, prepare for “contingencies” and, crucially, “be ready to communicate and execute policy changes [on] short notice.”
The post-financial crisis era was defined by predictable monetary policy, with prospective tweaks telegraphed months (and even years) in advance. Changes were implicitly submitted for the market’s approval and effectively subject to veto. Equities could voice their displeasure by selling off, while rates communicated through the curve. Rarely was it the case that policymakers chanced anything like a “short notice” pivot, let alone an aggressive, hawkish U-turn like that currently roiling markets in the US.
With apologies to anyone who’s owed, the IMF’s growth revisions are scarcely worth mentioning. Nobody trades on their outlook, and it feels like every other update is a cut. However, the Fund’s comparatively downbeat assessment was relevant Tuesday in the context of growing concerns about the possibility that Fed hikes are poised to play out against a decelerating US economy.
The IMF’s cuts were mostly explainable by way of downward revisions to the outlook for the US and China. “A revised assumption removing the Build Back Better fiscal policy package from the baseline, earlier withdrawal of monetary accommodation and continued supply shortages produced a downward 1.2 percentage-point revision for the United States,” the Fund said, adding that “in China, pandemic-induced disruptions related to the zero-tolerance COVID-19 policy and protracted financial stress among property developers have induced a 0.8 percentage-point downgrade.”
When it comes to the Fed, stocks and the risk of exacerbating what’s now guaranteed to be a fairly sharp slowdown at least relative to what would’ve been the case had key fiscal measures (i.e., the expanded Child Tax Credit) been extended, Powell needs to be careful he doesn’t wind up in a hamster wheel. I alluded to this on Monday.
The equity rally accounts for the majority of the easing in financial conditions since the onset of the pandemic, or at least if you go by the components of Goldman’s widely-followed index . Note the difference between the dark and light blue lines in the figure (below).
A ~20% decline on the S&P would tighten financial conditions materially, even in the absence of any knock-on effect in credit. Powell is very sensitive to financial conditions and thanks to the 2018 experience, he’s acutely aware of how quickly things can go “wrong.”
Already, the market is previewing what could happen if Powell even so much as nods to the link between falling equity prices and financial conditions.
“Look at the market’s behavior around ‘four hikes’ as the ‘FCI tantrum’ pivot point,” Nomura’s Charlie McElligott wrote Tuesday. “We began pricing more than four hikes in 2022 and equities then accelerated their tantrum to such a violent extent that [at Monday’s lows], Fed funds futures implied hikes for 2022 got hit down to ‘just’ 3.7 hikes,” he remarked. “Every time we sell off, markets price in a slightly more dovish Fed, which rallies equities to a point where we can price in a more hawkish Fed.”
That’s the hamster wheel. And, as McElligott went on to remark, “any potential acknowledgements [or] hat-tips” by Powell to financial conditions in the context of the equity selloff would surely be read as dovish by markets, which would then set up a rally. “The danger is that you could have a grotesque dynamic develop where… the market would then try to push for more and hold the Fed hostage [by] running valuations… back up in the face of an FOMC which was just supposedly committed to pushing-back” on excesses via tighter financial conditions, he said.
In essence, Powell will be fighting his own 2018 demons when he endeavors to stick to the hawkish script in order to reassure politicians that the Fed is truly committed to the inflation fight.
It won’t be easy. While there’s an argument to be made that growth is more robust this time around, and thus the risks associated with double-barreled tightening aren’t as acute as they were in 2018, evidence to support a slowdown narrative is mounting. The IMF’s cuts served to underscore the point.
“Cyclicals have not outperformed defensives, in line with the path of breakevens, which have started to decline more recently,” Goldman’s Christian Mueller-Glissmann said Monday. “Indeed, growth expectations across assets have started to deteriorate, especially in the past few days,” he added, noting that the bank’s RAI PC1 Global growth factor “has started to decline sharply.”
“Besides tighter financial conditions, this likely reflects concerns over the Russian/Ukraine tensions, weaker US manufacturing and (while early) a somewhat disappointing earnings season,” Goldman’s strategists went on to say.
There’s also a key difference between now and 2018 — namely, the necessity of hiking rates to bring down the highest inflation in 40 years.
“By forcing a correction in equities, the Fed [was] implicitly tightening financial conditions,” Deutsche Bank’s Aleksandar Kocic wrote, recalling 2018, when a 15% decline in stocks equated to roughly one 25bps hike. “This meant that rates could potentially have less need to rise in the future,” he said.
In 2022, by contrast, policymakers need to be wary of doing anything that might throttle the economy. Four years ago, the Trump tax cuts were in play and although global PMIs looked shaky and the trade wars were raging, there was nothing like the kind of ambiguity that exists currently. The US economy was stable, the tightening cycle was comparatively mature (in 2022, it hasn’t even started yet) and there was no real urgency in the Fed’s hawkish bent. In 2018, they were just trying to find neutral. In 2022, they’ll be battling 7% inflation. As discussed here on Tuesday morning, Powell (really) needs the economy to hold up if that battle is supposed to last longer than a meeting or two. As Kocic put it, “tightening cycles are usually funded by growth — there has to be enough growth to allow rate hikes.”
Of course, none of that is to suggest Powell should waver in the face of a 10% equity swoon on the excuse that the read-through for financial conditions could ultimately curtail the Fed’s capacity to hike rates and thereby the scope for battling inflation. Rather, the point is that thanks to what one certainly imagines is a mild case of post traumatic stress disorder from 2018, Powell will have to work hard to resist the temptation to acknowledge the equity-FCI link when he’s invariably asked about it during Wednesday’s press conference.
He “should” simply reiterate that the Fed monitors a variety of indicators when it comes to assessing financial conditions and note that no one metric takes precedence over the others. If he absolutely has to, he could say the Fed will “of course” be cognizant of financial conditions as they remove accommodation. Then leave it at that.
But really, it’s a no-win. Failing to nod at stocks poses a downside risk for equities. Powell isn’t Janet Yellen. Markets know he’s tone deaf, so they’ll make allowances, but if he comes across as deliberately obtuse, stocks might decide to punish him by plunging. If additional losses were to spill over into credit, the whole game plan could be up in smoke by the middle of next week, forget about March.
On the other hand, if he so much as winks at stocks on Wednesday, they’ll probably surge, leading to looser financial conditions and raising questions about the Fed’s resolve. Then he’s a hamster.
8 thoughts on “Powell Faces 2018 Demons With Stock Crash Dilemma”
Stocks and credit are linked closely. Usually credit leads stocks. This time around, stock market is having a tantrum first. The reason is that much of the equity market has a long duration and the economy is more leveraged with a lower long term baseline growth rate (leverage and demographics). Powell would be wise to stick to his guns here, only in the sense of tapering and then discussing liftoff. He should at his press conference state that the FOMC will raise rates as necessary, but do not have a predetermined path of timing, speed or magnitude and will work to use monetary policy to reduce inflation to the extent possible. It was a mistake for the Fed to start talking about 3-4-5 hikes. They know they have to reduce accomodation. That is it.
@RIA, I’m afraid that in that event stocks would rip and (less confidently) that rates would fall.
If Goldman is right and equity prices are the largest part of loosening/tightening, then Powell would have inadvertently loosened by his words, and potentially made things worse. I don’t think he’s got the Greenspan gift of skillful obfuscation.
I admit I’m set up such that a market rip up led by crapcos and ARKK is exactly what I don’t want right now, so I am biased.
Powell, contrary to his statements about data-based (past-based) decision making, must be relying on macro predictive models so we don’t get into the boom and bust cycles of yesteryear. The pandemic was a massive shock to a dynamical system with bifurcations: tiny changes to inputs cause the system to snap to a different stability path.
The only way to control such a system is to have a model, make decisions based on the model, and tweak the model as the outcomes are realized. You can learn about the system and make your model predictive enough if and only if your control inputs are tiny.
I posit they’ll mention that they’ll keep moving slowly as long as inflation is shrinking but that they’ll act decisively if there is data showing inflation is still increasing (their inflation predictions showed it should have peaked already). Such message is scary enough to speculators to keep them at bay and supportive enough that long-term investors won’t panic.
In any case, hats off to central bankers around the world. It’s not an easy job: decisions must be technical and research-based, but the pressure is very political and personal.
“The only way to control such a system is to have a model, make decisions based on the model, and tweak the model as the outcomes are realized. You can learn about the system and make your model predictive enough if and only if your control inputs are tiny.”
@Manuel Lopez you are obviously a thoughtful, kind, and generous spirit when it comes to your fellow man. That said ?, the above quote I selected is “scary” to me. The Universe, at least, the one I’ve become accustomed to, indiscriminately smashes our delicate models like boys kill flies. When the Economy goes where no Economy has gone before, it probably needs a Chuck Yeager on the stick, or at least waiting in the ‘wings’ close by, instead of a tinkering watchmaker. Don’t get a bee in the bonnet over anything I scribble. I know you are attempting to formulate a reasoned interpretation of a staggering complexity in the confines of a comment box. Within such confines I think we might do better sometimes to make our propositions in poetry.
Maybe it was the juxtaposition with the first paragraph’s, “the pandemic was a massive shock to a dynamical system with bifurcations: tiny changes to inputs cause the system to snap to a different stability path”, that jarred me? At first glance it seemed as though these were two incompatibles being called upon to serve the same end. Until I remembered a line I’d read earlier today, “wisdom is the co-existence of contradictory truths…”. That said ?, I go along with what you “posit” in paragraph three, mostly. “They’ll keep moving slowly”, sounds like Powell so far. The possible fly in the ointment concerns, “data showing inflation is still increasing”. Does that suggest an aggressive or excessively hawkish Powell means Thursday and Friday inflation related Economic releases will likely not support the “transitory” inflation confabulation? Meaning, if one is inclined to capture as much of the bubble gains remaining as possible, then sell Wednesday. Whereas, a “tiny” moves Powell, suggests he still believes in the “transitory/temporary” inflation narrative? Meaning, pile in Wednesday.
What happens in a three-axis stall?
Did the prior experience help the next time?
This all seems contradictory to me. If you’re leveraging monetary policy to fight inflation, it seems counter to expect that inflated stocks wouldn’t also be impacted. How many index records have been set in the past 5 years? Is the expectation that we just continually always set new records? Inflated stocks are a reflection of inflated housing, inflated used cars, and inflated consumer prices. If you want to reduce those prices then stock prices must fall too. Otherwise we just all end up with a bunch of worthless Dinarius’. Instead of being upset that telegraphed QT and rate hikes are causing stock valuations to tumble, everyone should be upset at themselves for ignoring Powell when he told all of us that this was about to happen. The market is completely dependent on the Fed at this point because of how far it’s been inflated and how reliant on debt it has become. I don’t like it either but it doesn’t change the fact that this is reality.
“Is the expectation that we just continually always set new records?”
Over time, yes. That’s absolutely the idea. Just ask Warren Buffett.
Remember: This is all make-believe. None of it is real. Dollars, stocks, bonds, corporations etc., are all figments of our imagination and a product of a system we created.
Given that, it’s hilarious that so many people are continually astonished that we (the people who created the system) continue to change the rules so that it keeps making the people who own the relevant assets richer.
Fighting this has (and always will be) a fool’s errand until some manner of societal breakdown and/or an ecological calamity “resets” things.
The US government/Fed are absolutely ok with as much inflation as they can get away with. Continually testing the waters and pushing to see how much they can get away with. When things go a little “too far” and the population gets testy- they pull back. But make no mistake, as soon as everyone calms down about inflation- they will be letting inflation ride again because inflating away the US debt is the only plausible long term path.
No model exists for this plan, however, what other long term plan is a possible contender, besides inflating away our massive debt? I can not think of another option that isn’t synonymous with “the end of the US- as we know it”.
You can laugh, but I know I am correct! (haha)
Hopefully the markets have a higher bar for Powell than to clear being “deliberately obtuse.” If he can’t top that the markets should panic…I still expect a hawkish statement, a steady and confident Powell, and a moderately volatile period of market activity over 1-2 weeks that may feel acute to many given the walk in the park feeling of the markets these past 12-18 months…perhaps we’re about to move from monetary morphine to monetary methadone…