Fed appears cornered after averting self-fulfilling meltdown
Short-term support for an economy in good health opens door to a surge in volatility
Seema Shah
Fed chairman Jay Powell is challenging the widely accepted view that policy rates act with a lag © Bloomberg
Not long after indicating further gradual increases in rates were on the horizon, the US Federal Reserve two weeks ago made a mysterious U-turn and signalled that its hiking cycle was over for now. This perplexing decision led many to believe it was a response to red flags about the US economy.
Doubtless, the global economy has slowed. But the various measures of US economic performance are almost universally strong. The latest ISM manufacturing survey rebounded smartly, indicating solid growth; retail sales have remained strong; inflation is near the Fed’s 2 per cent target; and the latest jobs report showed tremendous payroll growth, beating consensus expectations by a wide margin.
The US economy is in rude health — recession fears were, and are, overdone. Jay Powell, the Fed chairman, pointed to factors such as slowing global growth, tighter financial conditions and geopolitical trouble. Yet on all three counts the world is more positive: stimulus measures introduced since last June should eventually stabilise China’s economy towards the second half of the year; the Bloomberg US Financial Conditions index is at its strongest in nearly three months; and negotiations between the US and China are reportedly progressing.
It seems more credible that the Fed’s decision is predicated on two factors. First, lingering slack in the labour market. The January employment report highlighted that robust economic growth continued to pull workers back into the labour force, pushing the participation rate higher and keeping a lid on wage growth. It is almost inconceivable that the labour market is operating at full capacity yet.
Second, a capitulation to markets; investors perennially talk about the “Fed put”, counting on the central bank to support equities by shifting to easier money when times get tough.
There is method to the madness of the latter. Market tantrums can feed on themselves as confidence starts to plummet — self-fulfilling market meltdown. If financial conditions deteriorate significantly, negative market performance might weigh heavily on business investment intentions and consumer confidence. This script appeared to be playing out in December. Investors seemed to catch the idea that a recession was on the cards precisely because the stock market was going down. As the market stumbled, sentiment among business leaders dropped too.
In December’s Duke CFO Global Business Outlook survey, nearly half of respondents said they thought the US would be in recession by the end of 2019, with 82 per cent predicting a slump before the end of 2020. The risk was that falling stock markets convinced business leaders that a recession was coming, and they began hunkering down to create the conditions to bring on a mild recession. Financial markets were at risk of not just being a leading indicator of recession, but a driver.
We exist in the perfect climate for the next downturn to be the result of a collapse of confidence.
At the time of the previous financial crisis there were approximately 300,000 tweets per day; 10 years on, there is more than this number in a single minute, or more than half a billion in a day.
The echo chamber to amplify market anxiety has never been greater.
The risks are significant. US corporate debt has reached record highs; a further deterioration in financial conditions could have quickly led to a sharp rise in corporate defaults, with clear negative repercussions for the broader economy.
By allaying concerns over policy overtightening, the Fed has avoided this scenario — for now. It has unleashed “animal spirits”, greatly reducing the risk of a self-fulfilling meltdown in the near term. It is difficult tactically to be short risk assets; robust growth and a patient Fed is certainly a favourable mix.
But as relief charges through equity and credit markets, there remains an inescapable fear that perhaps the Fed’s short-term support for an economy that was already in good health opens the door to a surge in volatility later in the year. A strong pick-up in growth from here is surely not desirable.
If job gains continue, the labour market will eventually reach full employment. Higher operating and labour costs would follow, driving up inflation. Inevitably, the Fed would have to reverse its recent dovishness. But by patiently waiting to see higher inflation materialise before it kicks back into action, Mr Powell is also challenging the widely accepted view that policy rates act with a lag.
The Fed would be on the back foot, forcing it to play catch-up by slamming on the brakes.
Responding to rising inflation with a delay can be just as damaging as acting prematurely. It may not be easy for the Fed to resume rate hikes without risking renewed collapsing confidence, throwing markets once again into disarray.
The equity market rally may have been extended but risk appetite will eventually be challenged again — and while the risk of a recession in 2019 is lower than it was two weeks ago, the risk of a recession in 2020 has now surely increased.
The aphorism that “expansions don’t die of old age, they are murdered by central bankers” was written for times like these. Enjoy the risk ride while you can.
Seema Shah is senior global investment strategist at Principal Global Investors
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