Why Might Fed’s Meeting Shock Financial Markets?

Since 13-14 December meeting, financial markets have been nicely cooperating with the Federal Reserve’s efforts to restrain inflation. They are doing the Fed’s work for it by creating tighter financial conditions and exhibit no panic.

But as the US central bank’s policymakers meet on Tuesday, an underlying question they face is whether the adjustment is happening too slowly.

The Fed likes to move gradually to avoid spooking markets. But if its leaders conclude they are as behind the curve on re-setting monetary policy as some believe, it could mean more abrupt moves with far-reaching consequences.

By numbers; since the Fed’s hawkish push began in mid-November, market moves have been consistent with the central bank’s goals of achieving tighter financial conditions in an orderly way.

Bond yields have risen substantially, but not because investors expect higher inflation. Rather, inflation-adjusted rates are rising. The real yield on 10-year Treasuries has risen 58 basis points since November 9. Stocks and other risky assets have fallen, but in an exceptionally orderly way. The S&P 500 is down nearly 8% from its early January high, but with no one-day drops of more than 2%. The frothiest corners of the market have sold off the most.

The risk for the Fed now is that its gradualism is still leaving market conditions too loose to do enough to rein in inflation. Even after a steep rise in last two months, for example, the spread between BBB-rated corporate bond yields and Treasuries was only 1.1% last week, compared to an average of 1.59% throughout 2019. Financial conditions are still extremely loose by any historical standard.

It might take some time of a hawkish surprise at Fed chair Jerome Powell’s Wednesday press conference to get the attention of markets, even if it makes for a volatile period on Wall Street.

It is not just the usual cranks and hawks raising this possibility. A measured shock could help better align financial markets and conditions with the Fed’s language and the economic outlook, without triggering undue volatility.

Powell could convey on Wednesday that the Fed might raise interest rates at consecutive meetings, unlike in the last tightening cycle. He could also indicate that the Fed is not constrained by the quarter-point-rate-hike-at-a-time norm of the last two decades, and could raise rates half a percent or more in one fell swoop. Goldman Sachs expects the Federal Reserve to enact four interest rate hikes this year but thinks more are possible due to the surge in inflation.

More dramatic steps would include announcing an immediate end to Fed bond purchases, instead of tapering those purchases through March, or even raising rates this week, a possibility futures markets assign only 5% odds.

Those more aggressive measures are more likely to achieve the goal of tighter financial conditions, but also stand greater risk of breaking things in the markets and the real economy, potentially undermining the choppy recovery.

A little bit of market volatility now might put the economy in a more balanced place down the road, but threading that needle will be no easy task for Powell and company.