Since the beginning of the year, investors have contemplated changes in the trajectory of monetary policy. The key question has been, will the tightening conditions that markets currently expect be enough to fend off inflation? The answer has been no, so expectations regarding the number of rate hikes and the amount of adjustment to the Fed’s balance sheet has steadily increased. Volatility ensued as markets priced those changing expectations.
Probabilities for a reversal of this dynamic are rising.
Financial markets and the economy are living organisms that slowly evolve by adapting to prevailing conditions. In recent decades, disinflation and enormous increases in leverage have made them far more sensitive to changing financial conditions. Given that, previous rate-hiking cycles and how the economy and markets responded to them provide little insight about how they will respond this time. The closest example we can reference is the truncated hiking cycle in 2018 when falling markets forced the Fed to back away from its plans. Conditions that led to that outsized reaction to a modest series of rate increases are even greater today.
Reduced expectations for monetary tightening would be positive for markets to a point. All else equal, looser policy supports financial asset prices. But there is a risk the Fed will view the current situation through a historical lens that no longer applies. If it does, there is a risk of a negative reaction in markets to policy changes that prove to be overly tight due to the economy’s structurally increased sensitivity to changes in monetary conditions.
