The Federal Reserve was supposed to leave center stage by the end of the year and let other factors play the leading role in determining asset prices in the advanced world and beyond. Instead, it has written itself an encore act that’s full of confusion.
Monetary policy was often the only game in town when it came to determining market outcomes for much of the last 15 years. Central bank policy measures and statements (also known as forward policy guidance) as well as market expectations of what they would do and say had a disproportionate influence on asset prices; at times, meaningfully decoupling valuations from economic and geopolitical realities.
For more than a decade starting from the 2008 global financial crisis, central bankers flooded the system with liquidity and floored interest rates. They pivoted sharply in the last two years to a highly concentrated cycle of rate increases, necessitated by the mistake of initially characterizing inflation as transitory, before moving to signal that rates will stay high for long.
The near exclusive focus on monetary policy was supposed to fade as we attained “peak rates” and retreated only modestly from there over time, accompanied by an auto-pilot shrinkage of bloated central bank balance sheets via quantitative tightening. Central banks’ deterministic influence on asset prices was to give way to other factors, particularly the outlook for economic growth, the smoothness of the last mile of the inflation fight, and the availability of funds to readily absorb the step-up in debt issuance due to large deficits and higher borrowing costs.
This is not what is happening. Rather than slowly moving to the wings, the Fed in particular reinforced its lead role last week by spurring massive price moves in virtually every asset class. Chair Jerome Powell’s words about the potential for interest rate cuts have reverberated around the world, influencing expectations of what other systemically important central banks will do.
This plot twist has been far from smooth. Less than 48 hours after Powell’s remarks following the last Fed meeting, policymakers were back on stage trying to walk back what markets happily labeled the “Powell Christmas Pivot.” When they had little impact, more Fed officials joined in, taking a different tack that involved explaining what Powell really meant to say. The confusion was such that a week after Powell’s comments, the specialized media was still debating what the Fed’s genuine policy signal had been.
This is not the only peculiarity. Powell’s remarks fueled bets that the Fed will cut rates more aggressively than the European Central Bank — even though the euro zone’s economic growth is anemic compared to America’s, and its economy is structurally weaker.
Rather than focus on what should be the key determinants of asset prices, we are again left to wonder how the two incongruities created by the Fed will be resolved in the coming year: first, how markets heard Powell and what he meant to say; and second, the market perception of a more dovish Fed relative to the ECB, which faces a notably weaker economic outlook.
In an episode of the latest season of the Netflix series “The Crown,” Princess Diana is warned that “the risk is that one normalizes the abnormal and becomes accustomed to living in the madness; and that’s when things really go wrong.” The warning could well apply to the relationship between the Fed and markets.
The prolongation, yet again, of an unhealthy co-dependency between a Fed, which is inclined to be dovish and overly talkative, and markets, which too often drift into being single-issue focused, risks evolving in a manner that goes beyond abnormal. It increasingly threatens the economic well-being of current and future generations, as well as overall financial stability.
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