Friday's Market Minute: The Fed's High-Wire Balancing Act

The U.S. stock market remains excessively bullish as investors will be watching for clues from central bank policymakers as to when the Fed may begin removing its crisis-era stimulus measures. The U.S. economy and labor market have quickly rebounded from the pandemic, and many observers suggest monthly asset purchases of $120 billion make little sense and indeed may be storing up speculative trouble when inflation is running above 5%. As prices for equities and housing have risen to even higher levels, attempts to push interest rates back to their normal historical levels have always been followed by a retreat in asset prices. Yet, the modest uptick in consumer price inflation in recent months is not yet on a scale that would require a drastic tightening in monetary policy.

While many investors expect that the Fed will announce a tightening of monetary policy in the near future, few anticipate Powell to announce the withdrawal of the central bank’s $120 billion-a-month asset purchase program at the conclusion of today’s Jackson Hole symposium. Powell’s speech will likely emphasize that the economic recovery is well past the crisis, and will informally acknowledge they are preparing to taper asset purchases in a carefully crafted manner. After all, Powell and company still have a fresh memory of his communication mistake when he said the pace of balance sheet reduction was on autopilot in December 2018. As far as a formal pre-announcement of tapering, the central bank’s rate-setting meeting in September is a more likely outcome.

The fundamental question posed by his policies is whether the great monetary loosening can be unwound without doing great harm to the economy. Indicators such as signs of increasing wage inflation would be an important measure for the decision on when to begin the taper. If inflation expectations remain anchored at 2%, the Fed is likely to wait it out. In that context, an abrupt move to tighten could be a costly mistake. If inflation continuously runs to the upside, that’s a problem the Fed wants to have, and they have the tools for dealing with it. The Fed’s high-wire balancing involves moving too slowly to unwind, and financial markets could continue to overheat. Move too quickly, and a major market correction would be a self-fulfilling prophecy rippling through the global economy.

Based on dialogue, we know that Powell is less worried about inflation than some of his peers. If he feels that Delta variant is the bigger risk, he will opt to be more conservative and put off signaling taper. If this is the case, stocks will progress higher, yields will fall, and the U.S. dollar will weaken. On the other hand, if he feels that a delay won’t make much of a difference because tapering this year is inevitable, stocks will descend from their highs, yields will rise, and the U.S. dollar will extend its gains against all major currencies. Either way, caution is likely to show up in the tone of the speeches and Powell could list out several conditions that could trigger a return to an accommodative stance. However, evidence suggests that if tapering should start in the fall, September will not only be defined by the bull run, but also increased volatility.

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