Federal Reserve policy makers don’t have an explicit target for US stocks or consumer borrowing costs, but they know something’s off when they see it, and there’s a chance that now is one of those times. The S&P 500 Index has rallied 17% from its June lows through Tuesday, and consumer credit is growing at one of the fastest paces ever — developments that seem antithetical to the Fed’s goal of curbing the worst inflation in 40 years.
The thing is, the problem isn’t uniform, and the Fed should avoid upsetting the whole apple cart. Instead of throwing out his interest rate road map, Fed Chair Jerome Powell is likely to try some deft jawboning when he speaks later this month in Jackson Hole. He just needs to convince markets that policy makers are committed to their fed funds projections and that they have no plans to cut rates in 2023.
The Fed, of course, fights inflation by raising interest rates and “tightening financial conditions,” which implies some combination of a stronger dollar, higher borrowing costs and shrinking stock portfolios. The Fed can push the short rate around all it wants, but its policy wouldn’t be terribly effective if financial markets didn’t react in turn. The policies work in part by making it harder to finance homes and automobiles and making people who own financial assets feel a little bit poorer and less inclined to splurge on consumer goods. Many indexes track the broad concept of “financial conditions,” including one from Bloomberg that includes such factors as money market spreads, bond market spreads, the S&P 500 and the Chicago Board Options Exchange Volatility Index. If you follow these indexes, it has looked recently as if conditions are loosening back up again.
But how’s all this working out in the real economy? The Fed’s interest rate policy has rapidly cooled the housing market and helped bring the boil off automobile prices. For housing in particular, it’s hard to argue that the central bank needs to push much harder than it is at this juncture. Housing starts are plummeting; buyers are retrenching; and the pace of home price appreciation is slowing drastically. As the newly released minutes of the July 26-27 Federal Open Market Committee meeting showed Wednesday, “many participants remarked that some of the slowing, particularly in the housing sector, reflected the emerging response of aggregate demand to the tightening of financial conditions associated with the ongoing firming of monetary policy.”
Indeed, home values are declining month-over-month in about a fifth of the 100 largest metro areas, according to Zillow data. As such, the current 5.5% 30-year mortgage rate feels appropriate for the delicate task at hand: The Fed needed to douse the market without entirely scaring builders away because the country badly needs additional housing supply to set the market on a sustainable path. If the Fed had a separate lever for housing (it doesn’t), its best play might be to leave mortgage rates be and see where the market settles. Certainly, this is no time to consider selling mortgage-backed securities from its balance sheet.
Next, consider the corporate bond market, which is in a reasonably good place itself. Clearly, many borrowers got their fill of new financing in 2020 and 2021 when rates hit bottom, and financing has clearly slowed, meaning the most wasteful and irresponsible projects of 2021 are no longer getting funded, but the real and economically viable ones are. The corporate bond market remains open for business — there’s no buyers’ strike — so liquidity constraints probably won’t precipitate a crisis anytime soon. Those are good and healthy developments that are consistent with the Fed’s inflation fighting mission.
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Finally, there’s the mighty dollar. It may have weakened somewhat in recent days, but on a trade-weighted basis it remains extraordinarily strong, curbing the cost of some imports around the edges (and helping inflation) and restraining exports. Is the top in? Perhaps, but the impact has already been felt in the rapidly cooling US manufacturing sector, which is already suffering from supply chain bottlenecks and a weakening Chinese economy.
Yet there are other parts of the economy where the Fed doesn’t seem to be getting through.
Start with consumer spending. On a nominal basis, it’s holding up fine, helped by a big jump in consumer credit, including on credit cards. A report Wednesday showed that retail sales without autos and gas gained 0.7% in July from June. Clearly, a few hundred basis points on their credit card APRs isn’t going to stop consumers. Americans also remain eager to make up for leisure experiences they missed out on during the worst of the pandemic. Carnival Cruise Line even said Monday that bookings were nearly double the level from the comparable period in 2019. Provided these trends have room to run, that’s fuel on the inflationary fire.
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To meaningfully cool consumer demand, the Fed might need to engineer a sentiment shift, and that’s where stocks come in. Stock traders have been the most overt financial conditions vigilantes. The S&P 500’s summer rally has put the S&P just about 10% below its all-time high as of Tuesday’s close, which means that investors are still up an impressive 38% since 2019. Even the meme stock crowd is up to its old tricks, with recent target Bed Bath & Beyond Inc. more than quadrupling in value since Aug. 4. Economists may quibble about the size of the marginal propensity to consume from wealth, but make no mistake: Stocks are the most visible feature of US financial markets, and they have a significant impact on the way Americans feel about the outlook, and this doesn’t feel like a market primed for inflation fighting.
All told, the Fed has some work to do, but the indexes that track financial conditions can obscure some of the complex developments unfolding under the surface. The Fed’s transmission mechanism isn’t broken — it’s just having mixed success — and an overreaction to the summer market rally may gum up the parts that are actually working. At times like these, Chair Powell’s best tool is his rhetoric, and he’s likely to use it when he goes before the microphone in Jackson Hole at the end of the month. -- Bloomberg Opinion
